Leverage is a huge tool for the real estate investor and being able to secure the best financing terms is one of the keys to the success of a deal. Sometimes, the right financing structure can even outweigh seemingly non-negotiable items, like the price.
Qualifying for a loan for a residential property is primarily based on the borrower’s DTI (debt-to-income) ratio and credit score. Also, it’s very typical to get a 30-year fixed term. For any property with more than 4 units, the investor needs to get a commercial loan, and the dynamics of it is quite different from a residential loan. We will compare the high-level differences, then the details of typical commercial loan terms, and the process of qualifying for one.
To start off, let’s discuss the different types of loans. Agency loans conform to Fannie-Mae or Freddie-Mac standards. Fannie Mae is short for Federal National Mortgage Association and Freddie Mac is Federal Home Loan Mortgage Corporation, and both of these government-sponsored enterprises buy mortgages on the secondary market, pool them, and sell them as mortgage-backed securities to investors on the open market. This increases the supply of money available for lending. Banks need to make sure that the loan conforms to the federal guidelines, then they can sell the loan to the agencies and get their money back for more lending. Qualification for agency loans can be a little more stringent. Often there are hefty prepayment penalties(to be discussed later), and these loans are only issued on stabilized assets with minimal vacancy and required rehab, but these typically offer the most competitive rates. Agency loans are also often non-recourse, meaning that the borrower isn’t personally responsible for any losses from the project.
Portfolio loans, on the other hand, come from the money that the bank actually has in their account. The bank can have their own criteria that do not conform to the agency standards, and they can vary from one bank to another. Often they might be more flexible in terms compared to agency loans, which can be suitable for value-add projects. Agency loans typically won’t allow rehab funds as part of the loan, and require stabilized assets with high occupancy and minimal rehab. Portfolio loans can have rehab funds as part of the debt, and can even offer interest-only payments for some period. Because the banks are lending their own money, they can set their own criteria. Some local banks may require at least one of the partners to be local to the area. Portfolio loans are usually full-recourse, meaning that the borrower is personally liable for any potential losses that may result from the project. With a non-recourse loan, the business loss can be limited to the asset, but the borrower won’t be personally responsible beyond that unless they’re found to be negligent or malicious in their actions.
Bridge loans are usually some sort of private money, where a company raises funds and does lending on properties that don’t conform to most lending standards. These will be generally higher risk projects such as new development, heavy rehab, or high vacancy buildings. Due to the higher risk profile, these loans will be given at much higher interest rates and shorter terms. They are often structured as interest-only payments, and the loan includes the purchase price and the renovation budget. Investors like using bridge loans for flips, vacant buildings, or heavy value-add projects. Due to the short term nature of the loan, the investor will need to refinance into an agency debt or a bank portfolio loan once the property is stabilized with rehabbed and occupied units.
There are other variations of loans, but the above three are the most common types of debts that an investor will take on during his/her investing career.
Now let’s look at some typical terms for these loans. Unlike residential loans, 30-year fixed loans are not common for commercial loans. Some agency loans may allow for longer terms, but more typical will be a 5 or 10 year term with a balloon payment at the end. It will be amortized over 20 or 25 years. What this means is that if a loan has a 5 year term with 25 year amortization, the monthly payments will be as if the loan was scheduled for 25 years. Then after 60 months, the balloon payment (full balance of the loan) is due. The investor must sell or refinance at that point to pay off the remaining balance. It can be seen that the investor must have a solid plan for the project and that the loan term needs to be longer than the projected hold period of the investment. Typically lenders will lend up to 75% of LTV(loan-to-value), meaning that the investor needs to come up with 25% down payment. The LTV requirements vary and some lenders may allow only 70% while some agency loans may allow up to 80%. For Bridge loans, instead of LTV, they use LTC, which stands for loan-to-cost. 80% LTC means that the lender will lend up to 80% of the total cost (purchase price and rehab budget).
Commercial loans will also typically have prepayment penalties, which ensure that the lender will get the interest payments they were expecting over the life of the loan. For example, a 3/2/1 prepayment penalty means that if the owner sells or refinances on the first year, he/she will be subject to 3% fee of the remaining balance. On year 2, 2%, and year 3, 1%, etc. This way, the bank can get some sort of guaranteed return on their money. Another form of pre-payment penalty is yield maintenance. Agency loans typically have this, and it is a more hefty penalty structure for prepayment of a loan. The exact calculation of yield maintenance is beyond the scope of this, but let’s say that we did a 10 year loan. And on year 2 we decide to sell and are subject to yield maintenance. What this means is that we will owe what the bank would’ve made in interest for the remaining 8 years! This can add up to quite a bit. The investor must be very familiar with the prepayment penalty structure of the loan and must assess that they are acceptable for the type of project that he/she is doing.
Earlier we discussed full recourse vs non-recourse loans. Portfolio lenders typically require full recourse, meaning that the borrower becomes personally liable for potential losses from the project, whereas for non-recourse loans the losses are usually limited to the property only. This becomes relevant when it comes to finding a loan guarantor. For commercial loans, the borrower usually needs to have net worth greater than the amount of the loan, and liquidity greater than 10% of the loan. This means that for a $10M loan, the borrower must have $10M in net worth and $1M in liquid assets. For these larger deals, it is common for the investor to find a guarantor to sign for the loan in exchange for a fee or a small equity stake in the deal. It’s easy to see that a guarantor will be much more comfortable signing a non-recourse loan as opposed to a full-recourse loan.
In addition to net worth and liquidity, there are several factors that commercial lenders consider when issuing a loan. Unlike a residential loan where their primary considerations are the borrower’s debt-to-income ratio and credit, commercial lenders are looking for the viability of the project, and the competence of the borrower. Then the net worth and liquidity are taken into account, and finally the income and credit of the borrower are of small considerations in the qualification process. The residential lender wants to know if the borrower will make enough money to make the loan payments, and the commercial lender wants to know if the property will make enough money to make the loan payments.
The bank will meticulously underwrite each deal, and make a determination of the viability of the project. They will assess the existing financial status of the property – current NOI(net operating income), cashflow, occupancy, and building condition. Then they will do rent survey, estimate the rehab cost, and model out a pro forma to estimate the future value of the property. One of the metrics that the lenders look for is the DSCR, or debt-service-coverage-ratio. This is a ratio of the NOI(net operating income) and the debt-service payments(mortgage). If the NOI is $130,000 for year 1 and the annual debt service payment is $100,000, the DSCR is 1.3. The DSCR shows the ease at which the project can pay the mortgage payments. The higher the DSCR, the better. Lenders typically look for at least 1.2 to 1.25 DSCR on year 1, but they vary. In addition, they will look at how much the property will cashflow, and what the value of the asset will be at the maturation of the loan.
Next, the lender will look at the operator of the project to see what kind of experience and competence they have. Have they done similar deals in the past with a proven track record? Are they familiar with the local market? Do they have a solid team of property manager and contractors? As a seasoned veteran, this won’t be a problem, but it can be a challenge for the newer investor. He/she can team up with an experienced partner and leverage that relationship in qualifying for the loan. The other way is to make sure that the property management is very qualified and reputable in the market, and possibly structure some sort of partnership or other arrangement where the interests are aligned. Local banks are more likely to lend to a newer investor, especially if they have a good impression of the borrower. Make sure to prepare stellar presentations for the project and the team, meet the banker in person, and discuss intelligently about the property, the team, and the project strategy.
The investor will typically reach out directly to the bank or work with a loan broker. The broker will leverage their relationships with various lenders and find the best loan for the investor depending on the project. The broker will take about 1% fee for loans under $10M. When reaching out to the broker or the banker, we need to make sure to put our best foot forward and introduce ourselves and our team(broker, property manager, lawyer, etc). We want to demonstrate competence and confidence by being able to share who our team is, what our plan is, and why we like this particular market. Also it will help to submit a bio of the team with pictures, experience, and credentials.
Once the property is under contract, submit the financial documents, and prepare a meticulous presentation for the project. Make an appointment to meet the banker in person, and thoroughly explain why we like the deal and how we can achieve success on the property. Show the detailed estimates of the renovation cost, schedule, and the pro forma financials for the life of the project. Include rental comps, market research, and other pertinent information regarding the project. Make sure to leverage the experience and competence of the team.
Next, the lender will require various inspections. The required inspections vary from one lender to another, but the most typical ones are the PCA (property condition assessment), phase 1 environmental inspection, a survey, and an appraisal. Make sure that all inspections are performed and the reports are submitted in a timely manner. It even helps to share with the appraiser the project presentation to show how we got to the numbers that we have, and if our presentation is good, it can influence the appraiser’s final report.
It can seem a bit daunting at first, but in some ways commercial loans are more accessible where we are not limited to our income and debt. We are able to qualify for loans much beyond our current income. And we are not limited to the number of loans like we are for residential debts(10, but it gets tough after 4). We do need to present our loan worthiness in various ways, but this is doable if the investor knows what to expect and prepares ahead of time. To summarize, the residential lender wants to know if the borrower makes enough money to make the payments. The commercial lender wants to know if the property can generate enough money to make the payments. Then they look at the experience and competence of the borrower. There are agency loans, portfolio loans, and bridge loans. They all have pros/cons and each are suitable for different types of projects. Commercial loan terms are different form residential loans, and we need to consider things like prepayment penalties, yield maintenance, and recourse/non-recourse. We need to make sure that we have a loan guarantor lined up if necessary, and prepare an impressive investor bio and project presentation. Meet the lenders in person and communicate our confidence in the project, team, and the market.
By: Ki Lee