Curious about commercial real estate? Luckily, ComCapFL has pulled together all of the basics of commercial real estate investing and compiled them into one place: the 2021 Guide to Commercial Real Estate Investing!
Read on for a comprehensive list of information on commercial real estate and financing, terms to know, definitions, explanations and more…
Commercial Real Estate refers to a building or piece of land that is used to facilitate business or generate income. Thus, commercial real estate is considered an investment, with the owners or investors typically leasing the space out to a tenant to generate monthly income.
Commercial real estate can also be occupied by the owner, such as when a welding business owns and occupies their own warehouse; or when a restauranteur owns and serves food out of their own building.
Unlike residential real estate, commercial real estate is not purchased by the investor for the sake of living in or on the property. While something like an apartment building (also referred to as a multifamily home) might first strike you as a residential property, it is actually considered a commercial property. This is because the landlord charges a monthly rent, and therefore achieves an income from owning the property, thus making it an income property.
While there are several categories and subcategories of commercial real estate property types, they are often categorized into four main groups, also known as the Four Food Groups of Commercial Real Estate. They include multifamily, industrial, office, and retail properties.
While multifamily housing is residential in nature, the primary purpose of a multifamily property as commercial real estate is to generate income by charging tenants rent.
Types of multifamily properties include anything with more than one unit, such as duplexes, townhomes, high-rise apartment complexes, and condominiums. They’re typically classified by their size/number of floors into either low-rise, mid-rise, or high-rise buildings.
While some are investor income properties, industrial properties are typically owner-occupied and exist for the purpose of manufacturing, assembling, storing, and distributing goods (for example: storage, warehouses, manufacturing plant trucking terminals). When it comes to an industrial property, a single business is typically the occupant of all (or at least 51%) of the space and the commercial property is fundamental to the operations of that particular business. Industrial properties are built to suit the specific needs of the business of which primarily occupies the industrial properties, and usually require complete renovation to host a different business.
Additionally, industrial properties may also contain office space. However, if the industrial property contains both a warehouse-style space and offices that are not manufacturer-specific, they could be considered flex warehouses, which fall into the mixed-use category (discussed in more detail below.)
An office building includes one or many office spaces, to be occupied by one or more businesses. They may be located in suburban areas or may be centrally located in large cities (often referred to as a Central Business Districts or CBDs). They are typically classified into one of these three categories:
Class A – the most high-end buildings with the best amenities, in highly desirable areas/markets
Class B – high-quality buildings with average amenities, in lesser-desired areas/markets
Class C – run-down buildings with little amenities, in the least-desired areas/markets
Each property classification reflects a different risk and return because each property is graded according to a combination of geographical and physical characteristics. Although there is no precise formula for how properties are placed into each class, these letter grades are assigned to properties after considering a combination of factors, including the age of the property, location of the property, tenant income levels, growth prospects, appreciation, rental income, and even the building’s amenities (including the lobby, elevators, inside floor access, valet, covered/open parking, and more.)
*It’s important to note that office buildings, like multifamily properties, are also categorized by size as either low-rise, mid-rise, or high-rise.
Retail properties contain one or more storefronts and include malls, strip malls, town centers, grocery marts, factory outlets, and more. Typically, large retail centers contain an anchor tenant such as a large grocery chain store, which draws customers to the shopping center.
Retail properties can be a mix of multiple-storefront buildings and standalone buildings. These stand-alone buildings are referred to as out-parcels and typically house banks or fast-food restaurants. (These can be part of the property’s income or sold separately to an owner-occupied business or other owners as an income property.)
Mixed-use properties are often considered the Fifth Food Group of Commercial Real Estate and are made up of a combination of two, three or even ALL FOUR of the aforementioned property types. For example, a mixed-use property in your neighborhood may be the apartment building with retail stores and restaurants located on its first floor. Mixed-use buildings like these are typically located in larger towns and cities, where space is limited.
Although the aforementioned property types are considered the core of the commercial real estate investment industry, there are additional property types that pose slightly more difficult challenges in financing and operation.
While special-purpose properties are also considered investment real estate, they are also more difficult to finance, since a typical special-purpose investment property has limited appeal. The appeal depends on the business that occupies the special-use property, which may cause it to be more or less liquid as collateral and ultimately, more risky to the investor.
Special-purpose properties include hotels, raw land, gas stations, theaters, concert halls, sports centers, senior living, churches and other places of worship, recreation centers, automobile sales lots, and even marinas.
Commercial real estate can also include land that is available for commercial development. Land as a commercial real estate investment can include land for building residential communities, but can also include land for farming and other agricultural business activity (depending on the zoning.) Raw land can essentially be used to build any of the Four Food Groups of Commercial Real Estate and Special-purpose buildings.
Now that we’ve discussed the types of properties that an investor might be considering, let’s take a look at the next part of the process – understanding the financing aspect of commercial real estate.
With residential mortgages, the lender’s decision to approve the loan is heavily reliant on the borrower’s personal income and credit. Lenders inspect the borrower’s personal credit profile and annual income and debts, placing a smaller emphasis on the property (provided it appraises for the intended sale price or contract purchase amount and passes minimal inspections prior to the closing.)
Unlike the residential mortgages, commercial real estate mortgages are used for properties with investment or business purposes. While most residential mortgages are uniform in property type (be they single family homes, townhomes, or condominiums), commercial property types are diverse and complex. This means that commercial properties require significantly more analysis and carry a much higher investor risk for the collateral. With that distinction comes an entirely different set of rules on how they operate.
To understand how a commercial real estate mortgage lender looks at a commercial property and potential borrower, in the context of making a loan, it’s important to realize the commercial lender is also an investor. Unlike residential lenders, which are more concerned with the borrower’s ability to pay their mortgage, the lender/investor is more concerned with the investment property’s collateral, and ability to generate sufficient cash flow in the form of net operating income to cover the debt service (payments of principal and interest).
[Net operating income, or NOI refers to the sum of all revenues (leases and other monthly fees) minus all the expenses required to operate the building. These expenses include property taxes, hazard and liability insurance, regular maintenance, and repairs. Expenses may also include an allowance for capital expenditures for the purpose of replacing roofs, HVAC units and other high-cost capital equipment that wears out over time, plus an allowance for vacancy and management fees.]
In addition to NOI, lenders consider the Five C’s of Credit Analysis (character, capacity, capital, conditions, and collateral), with the most weight given to the capacity, or the borrower’s ability to debt service the loan based on the underlying property’s NOI.
Now that we’ve covered commercial lenders and their priorities, we can explore the different types of commercial loans that are available. Before we dive in, let’s define the important elements of a typical commercial mortgage or loan.
It’s very important to know the elements of a commercial mortgage or loan and how those elements work together to meet the requirements of your commercial real estate investment. Depending on the situation, the elements of a commercial mortgage or loan change and adjust to suit the lender and the borrower requirements. (For example, if the borrower needs to close as quickly as possible, these elements would change to account for the additional risk that the lender would assume by expediting the processing of the loan.)
The elements of a commercial real estate mortgage include:
Now that we know the elements of a commercial loan, let’s explore the many different types of commercial loans that are available.
Conventional loans refer to commercial mortgages that are secured by a lien position on the commercial real estate of which it is financing. Eligible property types include the Four Food Groups of Commercial Real Estate as well as hotels, churches and worship centers, and mixed-use properties.
Conventional commercial loans typically employ a maximum LTV of around 70% (depending on the deal, can be approximately 10% higher or lower), with terms ranging from 3-15 years and amortizations in the 10-30 year range. All of these numbers vary depending on the lender and the strength of the deal.
Conventional loans may be non-recourse, limited recourse, or full recourse.
Conventional loans typically have a maximum LTV of 75-80%, while some lenders can stretch up to 85% in limited circumstances for financially strong transactions. Borrowers should expect to have hard cash equivalent liquidity , while being able to maintain a post-closing liquidity (PCL) sufficient to service their debt at the levels dictated by the lending institution’s credit department. Most conventional loans also call for an overall net worth equal to or greater than the loan amount requested.
Conventional loan transactions will need to be able to meet a Debt Service Coverage Ratio or DSCR of 1.15x or more (depending on the program). This ratio is calculated by taking the adjusted NOI, and dividing the annual debt service by the anticipated amortizing term and interest rate.
A commercial refinance loan allows the borrower to renegotiate the terms and conditions of an existing loan, typically at a lower rate. However, the owner can also opt for a cash-out refinance loan.
A cash-out refinance requires the owner to have significant equity in the commercial property, as the refinance deal is considered a lien against the original mortgage. These refinance loans are most helpful in the case of needing to complete renovations, repairs, purchasing new equipment, replacing the roof, and more. In addition, these loans can also be leveraged to provide liquidity to purchase more CRE. While fast cash-out refinance loans are also available, they also usually carry a higher interest rate than the original loan for the commercial property.
Construction loans are exactly what their name suggests – funds intended for constructing a commercial building or providing renovations/modifications to an existing commercial building.
Construction loans carry significantly more funding requirements. The borrower must provide a blue book of the projected plans, including blueprints, floor plans, cost projections, and a list of suppliers and contractors that will be used. A licensed, reputable builder must also be attached to the project (unless you are a qualified general contractor with a history of success, but this is rarely accepted.) In addition, the property must be appraised, and the borrower must have proof of income, good credit and at least 20% to put down on the loan.
Bridge Loans bridge the gap during times when financing is needed but not yet available. They are also known as gap financing, interim financing, or swing loans.
Both corporations and investors may obtain bridge loans, which can be customized by the lender for many different requirements. These requirements may include making improvements, renovations or repairs to CRE prior to a permanent mortgage. Bridge loans are also used for tenant improvements (TI‘s), lease-up and other expenses in the interim or while stabilizing a property, all which help the borrower qualify for better rates and terms.
One use of a bridge loan is to utilize the equity in their current commercial real estate for the down payment on the purchase of another investment property until securing a permanent financing solution. While bridge loans are primarily secured by commercial real estate, these loans may be backed by other forms of collateral, including business assets.
A bridge loan may also allow the borrower to meet current obligations by providing immediate cash flow. Bridge loans are usually short-term, averaging in terms of only 12-24 months. Generally, they are interest-only, but an amortizing payment is may be required to service the debt. The rate may be at a slightly higher interest rates than a permanent mortgage, however, the monthly payment or cost of debt service is generally about the same.
Commercial Mortgage Backed Securities (CMBS), also known as Conduit Loans, are an extremely attractive option for stabilized properties with national credit tenants. These loans offer the most competitive rates, generally lower than any other bank mortgage option, with fixed rate terms of 10 years. Since the collateral is required to be a high-quality, stabilized income property, the rate is fixed against a margin such as US Treasuries, or LIBOR (now SOFR).
The conduit mortgage is a regulated security with a fixed period and return. CMBS mortgages have two distinct characteristics: they are technically not prepayable (and if they are, will have a yield maintenance penalty.) They are assumable by another qualified sponsor, which creates a unique, intrinsic value to this class in the event that interest rates are rising. CMBS mortgages also have special provisions in place to protect the mortgage in the event of any malfeasance or potential losses.
A conduit loan is packaged into a pool with other similar-type commercial loans, then securitized and sold in the secondary market to institutional investors. The loans in the pool are held in trust and the stabilized property and cash flow serve as collateral for the mortgage-backed security.
There are two main types of CRE debt instruments that may be used with senior debt to increase required liquidity, reserves, or cash assets to a project when needed. The two main types of these CRE debt instruments are Preferred Equity and JV (Joint Venture) Equity.
Preferred Equity is used when a minority of the liquidity is required, and is priced at an IRR less than Joint Venture equity (which provides a majority of the liquidity and prices higher accordingly.) Preferred Equity may be used when the liquidity requirement is less than 50% of the total cash or liquidity value. Preferred Equity is less costly than JV Equity, with its pricing based on an IRR formula (Internal Rate of Return), consisting of an equity component plus a coupon rate.
JV Equity may be used when cash liquidity or reserve requirements are more than 50% of the total liquidity available. JV Equity is priced higher than Preferred Equity, but with similar uses and characteristics including an IRR percentage-based pricing formula.
A Hard Money or Asset-Based loan is a type of mortgage that is secured by real property, typically from private money lenders rather than banks. Hard money loans are usually considered loans of last resort or short-term bridge loans, but may also be used to purchase non-income producing property such as land. Thus, they have a higher cost and lower Loan to Value (LTV) ratio, generally a maximum of 50% LTV. The basis of the loan is the value of the hard asset, or the underlying real property, making the hard asset the primary collateral. Due to this, these loans are fairly easy for a borrower to obtain.
Hard Money loans are only offered in periods of less than 24 months and on an interest-only debt service, rather than amortizing.
Hard Money loans are useful in many circumstances for early-stage and/or land acquisition for large projects, or in a time crunch when credit or documentation is unavailable, or when deposits or a contract are at risk.
Hard money loans may be used in turnaround situations, in short-term financing, and by borrowers with poor credit but substantial equity in their property.
Mezzanine financing is a hybrid of debt and equity financing that allows a lender the right to convert to an equity-interest in the company or project in case of a default (generally after other senior lenders are paid).
Mezzanine financing allows for greater flexibility whether or not additional equity instruments are attached to the debt. Frequently associated with acquisitions and buyouts, Mezzanine financing may be used to prioritize new owners ahead of existing owners in case of bankruptcy.
Mezzanine financing is one of the highest-risk forms of debt, as it bridges the gap between debt and equity financing. It is inferior to pure equity but superior to pure debt. However, as it often receives rates between 12% and 20% per year, it’s generally used as a short-term solution in terms averaging 12-36 months.
This special class of CRE loans may cover tenant improvements and lease-up expenses, allowing an investor to make improvements and cover the costs of lease-up expenses prior to stabilizing a recently improved property.
Investors may use these special CRE loans with a permanent purchase or refinance loan before the collateral is fully stabilized.
Alt-A loans are especially useful for properties that are considered one-off a prime loan. Mixed use, non-conforming and rural sub-market properties that normally wouldn’t be considered for a commercial mortgage by the corner bank may find ample programs with Alt-A, along with a multitude of rates and terms.
Freddie Mac, Fannie Mae, and other agency programs provide incentives or insurance to lenders. This allows them to take on more risk for CRE mortgages by using these programs.
The Federal Home Loan Mortgage Corp., also known as Freddie Mac (FHLMC) insures many multifamily loan programs for multifamily housing, student housing, senior housing, or affordable housing properties. These mortgages may be held in the FHLMC portfolio or sold to bond investors. Terms and options may include fixed or floating rates (which may or may not include an interest-only period) and are typically amortized over 25-30 years. (Note: Shorter-term programs of 5-7 years are available through the PPP, which include fixed rate and hybrid loan choices.)
A Federal National Mortgage Association mortgage, also known as a Fannie Mae mortgage, offers the most competitive terms. These include fixed and floating rate financing for multifamily properties, including apartments, student housing, affordable housing. These terms are especially competitive when paired with the Low-Income Housing Tax Credit (LIHTC) program, for assisted living and other healthcare facilities, mobile home parks and more.
Fannie Mae financing is also an option for financing properties previously under HUD legacy programs that are being converted to Section 8 housing under the Rental Assistance Demonstration (RAD) program. However, prepayments can be an issue, and qualifying can be challenging, as Fannie Mae loans require very experienced borrowers with strong financial statements and rigorous property underwriting.
Alternative documentation is a process designed to expedite loan approvals in cases where the full documentation may not be available. For these types of loans, the lender accepts alternative documents from the borrower, such as verification of income, made on the loan application.
In a Full Document loan, the borrower provides all forms of financial documentation including tax returns, personal financials, credit and historical & current property operating statements and rent rolls.
Light Documentation (Lite Doc) loans require the borrower to provide a less stringent version of financial documents that may include W-2s, paycheck stubs and bank statements. The loan decision is weighted on lighter underwriting requirement and examination of the applicant’s financial documentation, and the associated income property documents.
These loans often offer more flexibility than conventional and traditional loans, and might be a good option for borrowers with special situations including recently acquired properties, properties acquired through REO or foreclosure sales, partially stabilized properties or urgent closing deadlines. These are also very useful when the collateral value is higher than the cash flow supports.
No Documentation (“No Doc”) loans require even less financial documentation than Lite Doc loans. These loans offer more flexibility than Full or Lite-Doc loans, and are also an option for borrowers with special situations, like having recently acquired or partially stabilized properties and when the collateral value is higher than the cash flow supports. They are especially useful alternatives for self-employed or recently divorced borrowers.
These loan decisions are based on no formal financial documents, but rather the individual borrower and collateral value. Lenders impute the income and expenses in a No-Doc loan decision based on the property type and location. Be aware that with No-Doc loans, since there is less concrete documentation, the lender risk is increased and thus rates adjust accordingly.
If you own a business and plan on purchasing a building for business use, then you may be eligible for an SBA loan. Your business must occupy at least 51% of the building to qualify for these loans.
These loans are insured by the Small Business Administration for up to 75% of the loan amount. The SBA is able to do this because it provides the largest federal loan insurance program which helps small business start, operate and expand, adding employment to the economy.
SBA loans are not actually funded by the SBA, but rather by a list of approved lenders. Of these lenders, some have received the designation Preferred Lending Partners or PLP’s which allows them to originate loans without the direct supervision of the SBA. The SBA provides Standards of Practice (SOP) guidelines outlining their standards for eligibility requirements, documentation, financial analysis, and virtually every step of the loan process for PLP’s to follow.
According to the SBA website, in order to be eligible for an SBA loan, you must:
These SBA loans are beneficial because they are the only loans available to most businesses, helping them to level the playing field and compete. The most flexible of the SBA loans is the flagship SBA 7(a) series. Covering amounts of less than $150,000 all the way up to $5 million, these loans may be used to:
An SBA 7(a) loan to can be used to essentially fund all of a business’s needs. The 7(a) loan rate and terms are set by the SBA – such as WSJ + 2.75% and 10 years for business only, or 25 years for businesses with commercial real estate (fully amortizing).
These loans are more specific than SBA 7(a) loans, with funding up to $30 million. To qualify, a business must be stabilized and and have an experienced commercial real estate owner. Projects that qualify for this type of funding include:
SBA 504 loans provide you with up to 90% LTV financing, fixed interest rates, longer amortizations, and no balloon payments. These loans offer the best rate and terms for a business and include a fixed-rate loan, amortized over 25-30 years.
*Note: While SBA loans offer the best of the best in rates and terms, they typically require a lengthy and particular application process. If you are looking to close in less than 90 days, you might need to consider a different form of financing.
Whereas banks might be the most top-of-mind choice for property financing, they are also the most difficult to work with when it comes to securing a commercial loan. Unless you have an owner-occupied building with a business that is in excellent standing with great credit – it’s more than likely that the bank won’t be your best bet. Also, they’re notorious for long processing times and last-minute reneging on their decisions to fund. (This is particularly prevalent in the post- COVID-19 environment.)
Private commercial lenders are non-institutional private money lenders that lend to small- and medium-sized businesses, or individual investors, specifically with real estate collateral. They typically require less paperwork and are quicker to fund. Many private lenders have specific specialties — some will only fund multifamily and mixed-use properties, while others are PLP lenders and only do SBA loans.
A common misconception is that private commercial lenders imply high fees and costs, but this is not always the case. Private money often carries less fees and closing costs, and often comes with interest-only payments versus principal and interest payments – so the actual payment may be similar to rates that are available on fully-amortizing loans. However, as previously mentioned, it’s best to focus on entire picture of the loan as it pertains to your needs and not to simply fixate on the rate. Sometimes it’s more important to consider the timing and solutions that fit the requirement, rather than simply focusing on the interest.
*Note: There is not much private money available, unless there is a CRE asset involved – that is the difference between private equity and debt!
Hard money lenders (or Asset-based lenders) provide short-term loans based on the value of the commercial real estate. These loans typically carry a lighter application process with quick approvals, making them faster and easier to obtain than a traditional commercial loan. Hard-money loans are a great option for those with credit challenges who want short-term financing options. However, because of the higher associated risk, these loans typically have higher interest rates and an LTV capped at a maximum of 50%.
Commercial-backed security lenders, also known as Conduit lenders, issue a security which is based on the commercial real estate collateral. The most notable benefits of conduit loans include the following: they are assumable if you sell the commercial real estate, and they are non-recourse. However, these loans are not for everyone and typically require a minimum loan amount of $5 million, and are reserved for well-stabilized properties with regional and national brand tenants (for example: a downtown office tower). They also require an experienced sponsor (borrower), and stable commercial tenants.
In addition, conduit loans have special provisions to protect the ROI in the event of poor management or other negative factors. They typically carry a standard term of 10-years and are not prepayable, or otherwise require stiff Yield Maintenance penalties – but they have other features most CRE mortgages don’t. Since they are primarily based on the cash flow from the collateral and the term is predetermined at a fixed rate, they are assumable by another sponsor. This is a unique feature that adds to the main attraction of CMBS, which is the low interest rate, typically lower than all other commercial real estate mortgages.
We have covered everything there is to know about the commercial property types, elements of a commercial real estate loan/mortgage, types of loans available, and types of lenders, but what does one need to apply for a commercial loan/mortgage? Applying for a commercial loan requires a lot of time and documentation (unless it’s a hard money loan, which typically closes in days with very little document requirements.) Whereas every loan and lender may ask for additional documentation, the standard ask typically consists of the following:
If your commercial real estate is being purchased for construction or a new/startup business, you may also be required to provide a Pro-Forma document. Pro-forma provides a financial model and outlook for the business in the future, or once the building is completed and the business is stabilized. These projections are realistic predictions based on past performance, including income statements, cash flow, balance sheets, and costs and liabilities, to name a few.
With everything that is happening with the economy and borrowing in 2020, it’s more important than ever to have a plan. While this is an incredible time to invest, it’s also more difficult than ever to navigate the commercial lending landscape. Instead of going at it on your own, you may want to consider starting the process with a Commercial Loan Specialist.
Unlike singular lenders or brokers who simply match you with a loan (and then leave you to fend for yourself,) a commercial loan specialist works with you and your specific requirements, qualifications, and goals to custom fit and close the commercial loan that is right for you. Often times, these specialists have funds of their own; however, they also have many more layers of resources, including being plugged into large networks. Commercial Loan Specialists spend years fostering relationships with lenders, brokers, banks, and more.
By beginning the process with a commercial loan specialist, you also get the benefit of saving the most important commodity – TIME. For example, when applying for a loan at the bank, one might not be approved and then will have to start the application process all over with a different lender. In contrast, if you apply for financing with a commercial loan specialist, the specialist maintains your application and simply adds or subtracts elements to fit requirements of the next loan. The commercial loan specialist works best in this way, by utilizing their often vast experience and creative solutions to make sure your loan – the right loan – closes.
By applying once and creating a partnership with a specialist who knows and understands your investment plan, you’ll save weeks or even months in approval and closing times – and you’ll save yourself the headache of having to reapply.
As you now know, commercial real estate investing is a broad, complicated business with many elements and possibilities to consider. Before investing in commercial real estate, it’s important to have a specific plan about what your investment/business goals are, and how your commercial real estate will help you achieve those goals. Knowing all of your specific requirements and qualifications will save you and your future lender lots of time and money. In addition, having an idea of what type of loan and lender that is right for you will also help steer you in the direction of success.
If you are a first-time investor, be sure to also check out our upcoming articles, with subjects like how to take advantage of opportunities in commercial real estate during COVID-19. After learning the basics in this article, gaining additional insight will help you immensely in becoming informed on your next steps!
As always, you can count on the commercial loan specialists at Commercial Capital Ltd., FL to keep you educated and informed on all current topics that are trending in commercial lending. For assistance on your commercial real estate loan or to explore your options, please give us a call today at (888) 959-1648 or email us at firstname.lastname@example.org.