Just like owning your own home vs renting Commercial Real Estate (CRE) can be a good investment rather than renting space. Commercial Real Estate are retail centers, office complexes, or other buildings that are used for business purposes. Financing of CRE is typically accomplished through commercial real estate loans: mortgage loans secured by liens on commercial, rather than residential, property
Lets take a look at commercial real estate loans: how they differ from residential loans, their characteristics and what lenders look for.
Individuals vs. Entities
While residential mortgages are typically made to individual borrowers, commercial real estate loans are often made to business entities (usually LLCs due to there liability protection and taxes).
In most cased the lender will require the principals or owners of the entity to guarantee the loan. This provides the lender with an individual (or group of individuals) with a credit history and/or financial track record – and from whom they can recover in the event of loan default.
Loan Repayment Schedules
A residential mortgage is a type of amortized loan in which the debt is repaid in regular installments over a period of time. The most popular residential mortgage product is the 30-year fixed-rate mortgage. Residential buyers have other options, as well, including 25-year and 15-year mortgages (the amount of years the payments are based on is called amortization). Longer amortization periods typically involve smaller monthly payments and higher total interest costs over the life of the loan, while shorter amortization periods generally entail larger monthly payments and lower total interest costs. Residential loans are amortized over the life of the loan so that the loan is fully repaid at the end of the loan term.
Unlike residential loans, the terms of commercial loans typically range from five years (or less) to 10 years, and the amortization period is often longer than the term of the loan. A lender, for example, might make a commercial loan for a term of five years with an amortization period of 25 years. In this situation, the investor would make payments for five years of an amount based on the loan being paid off over 25 years, followed by one final “balloon” payment of the entire remaining balance on the loan. For example, an investor with a $350,000 commercial loan at 5.75% would make monthly payments of $2,201.87 for five years, followed by a final balloon payment. Balloon payments are usually renewed by the lender is the loan and property is performing to standard.
Another way that commercial and residential loans differ is in the loan-to-value ratio (LTV): a figure that measures the value of a loan against the value of the property. A lender calculates LTV by dividing the amount of the loan by the lesser of the property’s appraised value or purchase price. For example, the LTV for a $90,000 loan on a $100,000 property would be 90% ($90,000 ÷ $100,000 = 0.9, or 90%).
For both commercial and residential loans, borrowers with lower LTVs will generally qualify for more favorable financing rates than those with higher LTVs. The reason: They have more “shirt in the game”, which equals less risk in the eyes of the lender.
Commercial loan LTVs, are usually 65% to 80% range. While some loans may be made at higher LTVs, they are less common. The specific LTV often depends on the loan category. For example, a maximum LTV of 65% may be allowed for a gas station, while an LTV of up to 80% might be acceptable for a owner-occupied commercial condo.
There are other programs that can allow you to put less down (ie. 10-15%) this is a loan that is offered by a bank and the SBA called a SBA 504 Loan. Click HERE for more information about SBA products.
Debt-Service Coverage Ratio
Commercial lenders also look at the debt-service coverage ratio (DSCR), which compares a property’s annual net operating income (NOI) to its annual mortgage debt service (including principal and interest), measuring the property’s ability to service its debt. It is calculated by dividing the NOI by the annual debt service. For example, a property with $140,000 in NOI and $100,000 in annual mortgage debt service would have a DSCR of 1.40x ($140,000 ÷ $100,000 = 1.4). The ratio helps lenders determine the maximum loan size based on the cash flow generated by the property.
A DSCR of less than 1 indicates a negative cash flow. For example, a DSCR of .92 means that there is only enough NOI to cover 92% of annual debt service. In general, commercial lenders look for DSCRs of at least 1.25 to ensure adequate cash flow.
Interest Rates and Fees
Interest rates on commercial loans are generally higher than on residential loans. In addition, commercial real estate loans usually involve fees that add to the overall cost of the loan, including appraisal, loan origination and appraisal or valuation fees. Some costs must be paid up front before the loan is approved (or declined).
A commercial real estate loan may have restrictions on prepayment. The most basic prepayment penalty, calculated by multiplying the current outstanding balance by a specified prepayment penalty. For Example a 5,4,3,2,1 means that there is a 5% fee on the original balance the first year, 4% of the original balance the second year and so on
Prepayment terms are identified in the loan documents. Make sure you understand this ahead of time and evaluated before paying off a loan early.
Owner Occupied vs Investment Property
Owner occupied are when a business owner operates his/her own business out of a commercial property for which their business is the sole tenant or anchor tenant or when the business occupies at least 51% of the building space. When purchasing or refinancing an owner occupied facility, there are a few ways you can finance the facility. You can do a traditional real estate note or utilize an SBA backed real estate note.
Investment properties are when you have third-party tenants occupying the facility or where your operating entity uses less than 51% of the total square footage of the property. Investment properties can also be apartment complexes or multi-unit facilities that are held in a corporate entity, most commonly a Limited Liability Company (LLC). When purchasing or refinancing investment deemed properties, a traditional real estate note is the only option for banks to conduct financing. SBA is unable to finance these types of properties.
What is a Cap Rate?
A Cap Rate in Commercial Real Estate is used for Investment properties to show the income that the property is expected to generate. The cap rate is used to estimate the investor’s potential return the investment.
The capitalization rate of an investment may be calculated by dividing the investment’s net operating income (NOI) by the current market value of the property, where NOI is the annual return on the property minus all operating costs. The formula for calculating the capitalization rate can be expressed in the following way:
Capitalization Rate = Net Operating Income / Current Market Value