How Does Financing Work On A Commercial Real Estate Transaction?

Jumping into the world of commercial real estate can be an exciting time… but figuring out the financing side of things can be overwhelming. If you’re feeling a little confused, don’t worry – we’ve got you covered.

This short guide will help you understand everything you need to know to get started.

First, the Important Terms

To start, let’s get you acquainted with some of the most important terms a bank would typically throw at you:

  • Interest rate: This one is easy – it’s just the rate of return the bank will make on the principal you owe them at the moment. It is usually based on a “reference rate” or benchmark like the US 10-Year Treasury Note (T10), the prime rate, or LIBOR. 
  • Fixed Rate: A fixed rate loan is considered less risky because of its predictability. It basically means the interest rate will not change if the economy changes.
  • Variable Rate: In contrast, a variable interest rate will change with the economy, adding another level of risk.
  • Amortization: Some loan payments are for the interest only and some are for the principal and interest. For the latter, although the payments are the same each month, the portion of interest payments is higher and decreases over time due to the idea that the principal is also being paid down.
  • Balloon or Maturity: Unlike residential loans, commercial loans usually have a date before the amortization period when the bank requires the note to be fully paid. This can be anywhere between 3 and 10 years, but there could be exceptions. Some may argue this is because the banks like to maximize their returns by only riding the amortization schedule during the period where most of the payment is interest. As operators, the balloon is the moment when we refinance or exit the property for something better. 
  • Interest-only period: Some loans offer a period at the beginning of interest-only payments (with no principal contributions) to free up your cash flow and help you stabilize the property. This can be anywhere from 6 to 36 months and can be negotiated.
  • Points or origination fee: Depending on the lender and broker, you will be paying a percentage (1-3%) of the loan amount in fees. This will be divided between the different parties involved and many times it’s money well spent (this is a relationship game). 
  • Prepayment penalty: Before the balloon, some banks will charge you fees if you pay the loan off before its due time. You have to be careful when signing a bank note because these could be as significant as 10% of the total amount. 
  • Collateral: Commercial real estate loans are backed up (collateralized, really) by the asset itself. This means that in the event of a loan default, the bank would legally take over the property to make up for their debt. 
  • Recourse: A commercial real estate loan can be recourse or non-recourse. A recourse loan means that the bank can go after the assets of the personal guarantor in the loan (usually the general partner or key partner signing on it). Both kinds of loans exist and of course, non-recourse loans are less risky.
  • Loan Position or Lien Priority: This term refers to the position on the deed or operating agreement in which each party involved in a deal gets paid upon a sale. This is important because it’s “first in, first out”, so in the event of an undervalued sale the later positions may not get all of their capital.
  • Stabilization: You call a property stabilized when it has been occupied at 90%+ for over 90 days. This has several consequences in the type of debt you can secure, which we will explain more later.

What type of financing is available?

In the last section, you learned about the different financing terms you should understand (and use) when talking about CRE.

Now, there are a variety of commercial real estate loans available, and it’s important for you to understand which, how and when they should be used:

  • Permanent Loans: Perfect for long-term needs and ideal for stabilized properties. A very popular flavor of these are “agency loans,” which are backed by the government agencies Freddie Mac and Fannie Mae and follow their underwriting guidelines. Although the name has “permanent” in it, they aren’t really so: they have an amortization of anywhere between 10 and 30 years and a balloon of anywhere between 3 and 10 years.
  • Bridge Loans: These are short-term loans held until you secure permanent financing. Typically you would use these during a transitory period of operation where you’re trying to stabilize the property. If this transitory period includes construction or a rehab, the loan would typically cover a large part of this but will have a higher interest rate to account for the risk.
  • Construction Loans: These provide essential funds for construction projects. We would categorize it as a type of bridge loan, as they typically serve the same purpose and have similar terms. 
  • Supplemental Financing: These types of loans usually come from the same bank that holds the permanent loan note, are also collateralized and can be used for renovations or other business plans. These typically come on “second position”, akin to a Home Equity Loan in the residential space.
  • Mezzanine Financing: This is a mix of debt and equity, which is great for filling financing gaps. It is a bit more advanced than the others, and usually offered by very sophisticated investors looking for a predictable return.

When exploring your financing options, it’s worth exploring different providers and chatting with banks, commercial mortgage providers, SBA loans, and private lenders. 

We have excellent relationships with lenders that we regularly use for our deals, so when investing with us you can rely on us to get the best financing possible.

What’s the loan application process?

If you’re ready to start your loan application but are unsure what the process looks like, here’s a quick rundown of what to expect:

  1. Pre-approval: This is an initial financial assessment to check your eligibility. This is the period where a lot of documentation about the sponsors and entities are shared with the bank.
  2. Application Submission: Once pre-approved, you’ll need to gather and submit your documents about the property. This includes the OM (Offer Memorandum), RR (rent roll), T12 (trailing twelve financials), sponsor’s UW (underwriting) and more.
  3. Underwriting: The lender will review your application through their own lenses and appraise the property. They may ask for other stuff like a feasibility study, financial due diligence on the past financials and ledger accounts.
  4. Approval and closing: Once underwriting is complete, the bank will finalize the loan details and secure your funds at the closing table.

Finally, your credit and financial history will play a big role in determining your loan terms, but most of the emphasis is placed on the property’s history. The stronger the credit history and the more stable the finances are, the better the interest rates and conditions you’ll be able to receive.

Understanding Loan-to-Value (LTV), Loan-to-Cost (LTC) and Debt-Service Coverage Ratio (DSCR)

When exploring real estate financing, you’ve likely come across the terms LTV (Loan-to-Value), LTC (Loan-to-Cost), and DSCR (Debt-Service Coverage Ratio). 

In the simplest terms, an LTV compares the loan amount to the property value; the lower it is, the better the loan terms you can get and less risky your investment is considered by an investor. Please note that the “value” of a property comes from an appraisal and not the purchase price.

On the other hand, an LTC compares the loan amount to the total cost of the property (which includes the purchase price and any renovation or construction cost).

Finally, a DCSR measures how well the property can cover its debt during operations; the higher the ratio, the better. Many banks place a minimum expected DSCR (between 1.2 and 1.4) to diminish their risk.

Want to find out more about commercial real estate transactions? Equis Capital is always here to help answer your questions. 

Please subscribe below if you need more clarifications or want us to demystify another topic.

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