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Nearly all commercial real estate deals are financed using some combination of debt and equity. The nature of that debt can take many forms – ranging from traditional bank debt to hard money loans, and many alternatives in between.
The source and type of debt used to finance a property are critically important and should not be overlooked by prospective investors. A sponsor’s ability (or not) to source low-cost debt can have a dramatic impact on a deal’s cash flow, thereby impacting an investor’s returns.
Consider the typical interest rate for a commercial real estate loan. The current interest rate ranges between 2.2% and up to 18%. But that is just the average estimate. Depending on your qualification, credit history, the type of loan you want, and the type of project you are investing in, your interest rate could be higher than the average maximum.
Many aspiring investors turned to real estate crowdfunding via investments in REITs due to inherent difficulties in securing a commercial real estate loan.
In this article, we look at the different types of commercial real estate loans, including which types of loans are most appropriate for specific situations. Read on to learn more.
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There are many different types of loans and mortgages that can be used to buy commercial real estate. It’s important to talk to several lenders to ensure you are getting the most competitive rates and terms.
For example, Bank A might be willing to make a 4.25% loan on a commercial building that is only 50% occupied. Bank B might be willing to give a 4.75% loan on that same property but with a one-year interest only period. At first glance, Bank A seems like the better deal. However, in this case, when an investor is buying an underperforming property, having a one-year interest only period might be worth the higher rate.
This gives the new owner some time to improve and lease up the building, thereby stabilizing it prior to principal payments kicking in.
Commercial real estate loans are much more nuanced than the loans used to purchase owner-occupied residential real estate. What may seem like a minor difference between two loan options, as in the example above, can have a major impact on the deal’s overall returns.
This is why it is so important for investors to consider the various loan options available to them, especially as market conditions change.
Here are some of the most common commercial real estate loan options that a sponsor, developer or investor will want to consider.
Traditional bank loans, often referred to as “conventional financing,” are the most common source of commercial real estate debt. A traditional bank loan can be highly customizable based on the deal and borrower’s profile.
Conventional financing can be obtained at both small, local banks and much larger, national banks. Smaller banks tend to utilize more local decision-making. For example, they may be willing to make a larger loan based on their understanding of the local market and the borrower’s track record of execution in that region.
Local banks will generally have a smaller overall balance sheet, so loan sizes may be capped, but for the “right” deals, those lenders may be willing to be extra aggressive in their pricing and terms.
As deal sizes increase (e.g., $10-20+ million), most borrowers will explore conventional financing through larger, national banks such as Bank of America, Wells Fargo, or USAA. The large national banks tend to have more rigorous underwriting criteria, which in turn, make their rates and terms less flexible than what a borrower might able to obtain through a local or regional bank.
Traditional banks, large and small, are usually considered “relationship lenders,” meaning that they want to know the borrower and the team behind the deal being financed. They will expect the sponsor to have “skin in the game,” which translates into upwards of 30-40% equity in a deal.
Depending on the lender, they may be willing to accept less equity in exchange for more substantial recourse. As the relationship grows and matures, these lenders are usually willing to work with the borrower time and time again – assuming the borrower remains in good standing with the bank.
Because traditional banks are heavily regulated, borrowers should expect to have an active lending partner that monitors each deal closely to ensure all loan obligations continue to be met.
Agency loans are those initiated by government-sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac. These are loan programs initiated by the federal government as a way of ensuring the American population has access to abundant and affordable housing. Therefore, agency loans can only be utilized for multifamily properties and typically, those properties must already be stabilized.
This limits the broad applicability of agency loans, but for borrowers who qualify, these loans tend to be the most competitive of all CRE financing options.
In addition to offering great rates and terms, agency loans are generally structured as non-recourse loans. They are also made available at long-term, low-cost fixed rates. Many will include an attractive interest-only period as well.
These benefits come at a cost: flexibility. Because agency loans are securitized, borrowers do not have the ability to easily modify their loan or prepay the loan without penalty.
To obtain an agency loan, a borrower will need to contact a loan originator that has been specifically approved to underwrite loans to agency guidelines. At the national level, these lenders include Walker & Dunlop, Berkadia and CBRE.
Like agency loans, commercial mortgage-backed security (CMBS) loans are issued through a conduit, usually a large national bank, who will make various commercial real estate loans and then package them up to sell off to the public as bonds.
CMBS loans are more versatile than agency loans. For example, they can be used for any property type. However, in practice, CMBS loans are generally only utilized when a long-term loan is needed for a property with existing, stable cash flows.
Given the nature of these loans, and the stability of these properties, lenders need to be less active and do not have to provide as much oversight during the lifetime of the loan.
One downside to utilizing a CMBS loan is that they tend not to be flexible. For example, if a deal over- or under-performs, the borrower does not have many options to modify the loan to better meet their needs.
CMBS loans are generally considered a fallback option for borrowers who do not obtain financing through a traditional lender, agency lender, or life insurance company.
The underwriting criteria for CMBS loans is less rigorous than these other alternatives—primarily because these loans will be packaged and sold to a third party—and therefore, they tend to be utilized most frequently in secondary and tertiary markets, or by borrowers who have less experience or a less-than-ideal track record.
Life insurance company, or “lifeco” loans, are similar to traditional bank loans in that the lender typically holds and services the loan. Therefore, for borrowers to qualify for these loans, a deal must usually meet certain criteria—e.g., be well-located, cash flowing, owned by a reputable borrower, and so forth.
Lifeco loans are primarily utilized by borrowers seeking long-term (10+ years) loans for stabilized, low-leverage properties. Many lifeco lenders will look for borrowers to have at least 40% equity in these deals.
These loans can be utilized for any property type, must are most commonly used for multifamily, industrial, office, and grocery-anchored retail properties. These deals tend to be larger and therefore, most life insurance companies will look to make loans starting at $20+ million, though there are certainly exceptions.
The U.S. Small business Administration (SBA) has several loan programs, including a few that can be utilized to finance commercial real estate. The two most prominent SBA loan programs are the SBA 504 Loan Program and SBA 7a Loan Program.
SBA 504 loans are loans of up to $5 million that can be used by small businesses interested in expanding or improving their operations. These loans can be used to purchase real estate, finance the construction of a new facility, or purchase equipment needed for the business.
These loans allow the borrower to invest just 15-20% equity, which is less than lenders would typically require on a more traditional commercial real estate loan.SBA 504 loans must be originated by a “Certified Development Company,” which is an organization that has been approved to partner with the SBA to provide these loans.
SBA 7a loans are loans of up to $5 million (of which up to $3.75 million is backed by the SBA) that can be used to finance owner-occupied commercial property. Because a substantial portion of these loans are guaranteed by the SBA, these loans are often utilized by borrowers with less than ideal credit. SBA 7a loans are typically provided by traditional lenders like Wells Fargo and JP Morgan Chase.
It is important to note that these loan programs can only be utilized for owner-occupied commercial real estate (i.e., a small business is planning to purchase a commercial property that they intend to use for their business purposes). In some cases, they can be used for hotel deals. They cannot be used for multifamily real estate.
Hard money lenders are third-parties who make loans at above-market rates. Whereas a traditional lender might make a loan at a 5% interest rate, a hard money lender might make the same loan at 12% or more.
Given the discrepancy between the rates and terms available at traditional lenders vs. hard money lenders, hard money loans are generally only utilized as a last resort. For example, a borrower may use a hard money loan in a situation where time is of the essence, and they need the cash on hand sooner than a traditional bank could provide.
A hard money loan may be used in the interim to advance a deal, while in the background, the borrower pursues a longer-term financing solution.
Hard money loans are also used in high-risk situations. It might be a high-risk deal (e.g., a development opportunity in a tertiary market) or the borrower may be considered high-risk given a lack of experience or lack of equity in the deal.
Typically, upon stabilizing a deal, those who have utilized a hard money loan will pay off this debt ASAP and secure more traditional financing.
A blanket loan, sometimes referred to as a “portfolio” loan, is a loan that finances more than one property at the same time. A key feature of a blanket loan is that the loan survives the sale of one or more of the commercial properties by which it is secured. A borrower simply needs to “retire” the portion of the mortgage that the sold property represents—they do not need to refinance the entire loan.
Blanket loans are attractive for investors who want to refinance a large portfolio of properties that would otherwise have variable loan-to-value ratios if financed individually. For example, a borrower looking to acquire a new asset with less equity than would otherwise be required by a traditional lender, may instead pursue a portfolio loan that covers other assets that have more substantial equity.
Therefore, on balance, the portfolio’s loan-to-value ratio will remain within the lender’s standard even if individual properties do not meet the same criteria.
Another benefit of utilizing a blanket loan is that it simplifies the financing for investors with multiple properties. They do not need to oversee and manage several individual mortgages; instead, they only need to manage one (albeit larger) loan at a time.
A short-term bridge loan is a type of commercial real estate loan that provides borrowers with short-term capital that can be used to purchase and/or improve a commercial property. Short-term bridge loans are generally only utilized until that property is repositioned and then refinanced or sold.
The borrower will then use the proceeds from the refinance or sale to pay off the bridge loan at that time.
Bridge loans are structured to be short-term, usually three years or less, sometimes with two one-year options to renew. As the name implies, they are intended to provide “bridge” capital to get a borrower from one source of financing to another.
Bridge loans tend to have higher interest rates than traditional commercial real estate loans. The rates can be anywhere from 50 to 200 basis points higher than a conventional bank loan, with the rate depending on the nature of the deal.
All too often, a real estate sponsor or developer will default to calling their existing lender when seeking a new commercial real estate loan. While this is a great place to start, most borrowers will want to cast a wider net. Some banks only offer certain loan products, while others offer alternative options.
It is important to understand all available sources of financing to ensure you are getting the best rate and terms for your commercial real estate deal.
When seeking a commercial real estate loan, borrowers will want to consider working with a commercial mortgage broker. A commercial mortgage broker will have strong relationships with all lenders in that area, traditional and non-traditional lenders alike.
The broker will be able to walk you through various financing tools that you may not have otherwise known were an option.
It is important for any prospective investor to understand the breadth of financing available for commercial real estate deals, as the cost of capital is one of the biggest expenses sponsors will incur.
Given the range of options available to borrowers, they will want to carefully consider the deal’s specifics when pursuing alternative options. This includes the anticipated loan-to-value ratio (including how much equity the sponsor will be directly contributing), current occupancy or length of time prior to stabilization, anticipated cash flows, and more.
Deals considered to be “higher risk” for one reason or another may have fewer financing tools available.
Nevertheless, sponsors should never assume that a certain source of capital is off the table—they should pursue all options to be sure they are locking in the best rate and terms, which will ultimately trickle down to the benefit of each individual investor.
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