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If you have never had to deal with commercial real estate financing, you may find it intimidating. That is certainly the case for most first-time commercial borrowers. Commercial real estate mortgages are quite different from their residential cousins in terms of both complexity and cost. But getting the facts before you apply for a loan should eliminate any fears about this fantastic business financing technique.
The Basics of Commercial Real Estate Financing
Commercial real estate financing is very similar to residential mortgage lending in that real property is pledged as collateral against a loan to either buy or refinance the property. A business may also borrow against the equity in property it owns, which like its residential counterpart can take the form of a business line of credit or a lump sum payment for any business purpose. Commercial real estate mortgages generally require regular payments of principal and interest -- commercial mortgage rates can be either fixed or variable -- until the loan is paid in full. Moreover, a commercial lender retains a security interest in the property throughout the loan term, with the same right to foreclose if the borrower defaults as a residential lender.
What distinguishes commercial mortgage lending from residential lending are the characteristics of the property and the borrower. Unlike residential mortgages, which are geared toward the individual and 1-4 unit residential dwellings, commercial property financing is designed for business entities -- both for profit and not-for-profit -- to mortgage nearly any type of retail, office, industrial, multi-unit (5+) unit residential, or just about any other commercially zoned real property.
Because of these property and borrower characteristics, commercial real estate mortgages are viewed as higher risk transactions by the lending industry. The limited marketability of commercial property and higher risk of borrower default translates to less generous terms and more conservative underwriting by commercial mortgage lenders than those found in the residential arena. If a lender has to take possession of a commercial property through foreclosure, it will generally have much more difficulty selling it to recoup its money than it would a house. To compensate for the greater risk, commercial mortgage rates are substantially higher as are down payment requirements, and loan terms are shorter (typically a maximum of 25 years).
Commercial mortgage lenders prefer a solid business borrower, but for newer businesses or companies that cannot meet the required financial performance standards, a personal guarantee of repayment from one or more of the firm's principals may be used to compensate.
A final important difference between commercial real estate financing and the residential variety is that commercial real estate mortgages are more expensive to process and close. Not only are they much larger loans on average than residential mortgages, but nearly every aspect of the "due diligence" phase -- from valuation, to title, to underwriting -- is more complicated and, therefore, more costly.
An Illustration: The "Vanilla" Commercial Mortgage Loan
To help you understand how commercial mortgage lending works in practice, here are the major characteristics of a standard "vanilla" commercial mortgage loan.
Debt Coverage Ratio
Commercial real estate financing is based primarily on the income of the property rather than the borrower. The lender will want evidence that the property will produce more than enough income to cover the mortgage payments. Generally, commercial mortgage lenders require the property to produce from 1.1 to 1.25 times the monthly mortgage payment in net rental income. For example, if the monthly mortgage payment is $2,000, the property should be producing $2,200 to $2,500 after all expenses are paid.
Commercial mortgage loans typically require a borrower to put a minimum of 25% down. A higher down payment may be required for certain properties that carry greater risk, newer companies or those without a solid track record of consistent profitability.
Commercial real estate mortgages normally carry deescalating prepayment penalties, that is, a fee due to the lender if the loan is paid off within a certain period of time after it is made. For example, the fee might be 5% of the outstanding balance during the first year, 4% the second year, and so on, with no penalty after the fifth year. For obvious reasons, prepayment penalties are a particularly important consideration for a business that may not wish to -- or be able to -- own the property long enough to avoid them.
Although these characteristics illustrate a “standard” in commercial real estate mortgages, you can find many lenders with flexibility in any of them. Generally, deviating from a standard will entail an offsetting adjustment in others to compensate for the increased risk. For example, an up-front fee or higher interest rate might reduce or entirely eliminate a prepayment penalty, while a personal guarantee from one or more company owners might reduce the required down payment.
Where to Go For Commercial Real Estate Financing
Commercial mortgage lending is widely available throughout the U.S. The three most common sources of commercial real estate mortgages are:
Naturally, most business owners turn to banks -- particularly ones with whom they have established relationships -- for their commercial real estate financing. On the one hand, banks tend to offer the lowest commercial mortgage rates; on the other, they are the most rigid in their lending. Many banks will refuse loans on certain classes of property or exclude companies from specific industries. They also require more documentation and may charge higher fees than other commercial mortgage lending sources.
Conduit and hard money lenders can fund commercial mortgage loans with less documentation and more quickly than banks. Because their money comes from private sources, insurance companies, and commercial lines of credit, they can be much more flexible in their lending. You will find that hard money lenders, in particular, will loan money at lightning speed on virtually any type of property with much less stringent criteria for their borrowers -- all at a cost: Hard Money Lenders charge significantly higher mortgage rates than banks.
For larger capital needs, companies often turn to private equity companies. Private equity companies can provide critical commercial real estate financing on the total cost of a project. The equity range is the difference between the total cost of the real estate and the amount the senior lender is willing to provide -- normally no more than 75 percent of costs. So, for a $5 million project, commercial mortgage lenders would typically loan no more than $3.8 million, leaving $1.2 million in the equity range for the borrower to fund. If the borrowing entity has $200,000 in cash to put into the project, it could consider a mezzanine loan or an equity capital investment to come up with the remaining $1 million. Private Equity Companies are quite versatile and they can provide creative, flexible financing solutions, but they expect a good return on investment, so their interest rates are considerably higher than those charged by commercial lenders.
Commercial mortgage brokers don't fund loans directly. Instead, a good broker will conduct a thorough assessment of your needs and research the programs offered by other commercial mortgage lending sources to find you the right mortgage solution with the most competitive rates and fees. A good commercial mortgage broker will have established relationships with many different lenders offering a wide variety of lending programs, giving you access to financing you might not be able to find on your own. As an added benefit, commercial mortgage brokers handle the tedious details of loan processing and packaging, making an otherwise complex transaction less stressful and saving you much time and energy. Using just any commercial mortgage broker could cost you either in up-front fees, a higher than market interest rate, or both. A good one, though, will orchestrate a smooth transaction with an optimal loan suited to your company's specific needs at a competitive rate.
With so many choices, it is important that you shop around, but the goal of your shopping should not be just to get the best rate. As is the case in residential mortgages, commercial mortgage rates and terms will vary from one lending source to the next. But with such a big financial commitment at stake, unless you have expertise in commercial real estate financing, you need a trusted advisor to both help you understand and to guide you through the complex process that defines a commercial mortgage loan.
Regardless of the source you ultimately use, a little preparation before you begin your search for commercial real estate financing will go a long way towards reducing stress and assuring a good outcome.
Preparation: The Key to a Smooth Commercial Mortgage Lending Process
When you are ready to begin your search for a commercial mortgage lender, some advance preparation will serve you well. The complex nature of commercial real estate financing means you cannot expect to "rate shop" multiple lenders with a few minutes on the telephone -- at least, not with any reliability.
Any prospective lender you contact should ask you for the following information, which is needed to give you an informed, accurate decision about your company's ability to borrow and the approximate rates and terms you can expect:
Having these items available will not only make your task easier, it will make it more likely you receive both an accurate quote and solid feedback on your loan request. Be wary of any prospective lender who will quote rates and terms without the required information. You could be in for nasty surprises later!
Commercial real estate financing is another of the business financing power tools available to your company. Unlike other types of credit for business, which typically have less attractive terms and a relatively short repayment period, commercial mortgage loans offer an excellent means to acquire property and manage risk with long-term, asset based financing, at attractive interest rates and with favorable tax treatment.