Commercial Real Estate

The Foundations of Commercial Real Estate Financing

By Venture Mortgage Corporation

Are you considering the purchase of your first commercial real estate property? It’s an attractive proposition: the first rule of building wealth is to increase assets and limit liabilities, and income-generating real estate, properly managed, will add to one’s net worth and increase one’s economic security. However, it is important to be a well-informed investor, and there are some key considerations that are especially vital for first-time commercial property buyers to understand. In the first segment of this series, we will begin to understand the wide world of commercial real estate financing.

1)      Understand property types: What type of property are you pondering? For many first time buyers, multifamily rentals are the default choice, as they are familiar with residential property as renters and/or homeowners. It could be that office, industrial, or retail properties are a better fit for your goals and career experience, but do keep in mind that the cost of acquisition for these property types are often significantly higher than the multifamily sector. Commercial properties are generally divided into five general categories: retail, office, multi-family, industrial, and special use (land and land development are a separate phenomenon that beyond of the scope of this writing). Within these categories, properties are further divided based on location and condition. The type and classification of the property you decide to buy is a very important consideration when it comes to obtaining financing and in calculating potential return on investment. Speaking of financing…
2)      Commercial real estate financing is potentially quite complex : Most commercial real estate buyers are familiar with the process of obtaining a residential mortgage, but financing a commercial real estate property is generally very involved and can be intimidating to first time investors. The loan origination process is unique to each property and buyer, and there are many lending sources, each with its own advantages and disadvantages. Investors should expect to come to the table with at least 20% down for the majority of properties, as lenders are generally not willing to go over an 80% loan-to-value (the ratio of the outstanding debt to the value of the property). This means that, for a $1,000,000 property, one should be prepared with a minimum of $200,000 toward the purchase. Appraisals are usually required, as well as a number of other third-party inspections and reports as a part of due diligence: these typically include environmental reports, title searches, an American Land Title Association (ALTA) survey, and more as requested by the lender. These third party reports, combined with loan fees and legal costs, can add up to thousands of dollars very quickly. Lenders consider a wide array of factors when they underwrite loans: for example, a particularly risk-averse lender may be uncomfortable lending on an 80 unit apartment building to a first-time borrower with no property management experience, even if said borrower comes with a considerable down payment. This is why it is vital to…
3)      Know your lending options: Did you know that you can borrow money from a life insurance company to purchase an office building? How can you tell which bank is best for a property in a secondary market? Do credit unions even do commercial real estate loans? How do you know if the rate you’re being quoted is a good one? Which lender is the best choice for me and my situation? There are ways to answer these questions and make informed decisions. A commercial real estate mortgage banking firm is a company that has established relationships with a wide variety of capital sources for the purpose of securing commercial real estate financing for borrowers. By shopping an investment to life insurance companies, banks, credit unions, agencies, and commercial mortgage backed securities (CMBS) lenders, the firm is able to inform the investor about the options available, simplify the origination process, and secure the most favorable rates and terms for the client. In some cases, such as with life insurance company lenders, loans are only available through commercial real estate banking firms (which will act as a conduit); by not consulting with a mortgage banker, borrowers are potentially excluding lenders who will offer the best available loan package. A consultation with an experienced mortgage banker at Venture Mortgage regarding a potential purchase is always complimentary. In fact, Venture Mortgage is only paid a fee if we secure financing and close a loan for you on your terms, and our many satisfied clients speak not only to the savings they realize with us, but also to the superior service they receive during the origination process and throughout the life of their loans.

In the upcoming segments, we will take a closer look at the loan approval process and answer the question, “What Are Lenders Looking For?”

We will also begin to the understand the fundamentals of the different property classes in “Property Types: How Commercial Real Estate is Defined and What It Means For Financing”.

Does Your CRE Investment Pass the Stress Test?

By Venture Mortgage Corporation

Lenders use DSCR as a first-look; commercial real estate investors would be wise to do the same.

(Read part one here.)

The Federal Reserve has opted not to raise rates in September 2015, but experts speculate that the rate hike has only been delayed for a short time. When rates do eventually rise, it will allow institutional investors and funds to deploy their assets in other locations – namely bonds – and will hopefully stop the chase after yield by purchasing real estate at 4%, 3%, or even 2% cap rates. This will be a good thing for the stability of the commercial real estate world: while it does correlate with rising interest rates for investors and the debt placed on properties, this should level out the “crazy” deals being done, or at a minimum, keep deals in check.      

It is vitally important to “stress test” any purchase or refinance you are currently pursuing by:

1)      Finding the 1:1 DSCR in terms of value and rents received.

2)      Considering changing cap rates: if a property is purchased at a 6% cap rate, evaluate what it looks like at a 9% or 10% (closer to historical averages) cap rate.

3)      Evaluating changes in market rents: if rents fall 5%, 10%, or 20%, what will happen to the ability to cover the debt service?

If very small moves in the market cause the property to be classified as underwater, it is probably a good sign to turn and run, or, at a minimum, start getting financial reserves in order to cover a potential shortfall.

To avoid this type of rate risk, lock in rates for the long haul. There are a variety of lenders offering 10 year, 15 year, 20 year, and even 25 year fixed rates on commercial real estate properties. A trusted and experienced Venture Mortgage Banker will be able to quickly assess your portfolio and help you to explore lending options to lock in rates for a long fixed-period. This will allow you to take risk off the table for the near and not-so-near future, as well as capitalizing on the historically low rates and high valuations we are seeing in the market today.

There are numerous other metrics, ratios, and tests used to determine the strength of a real estate investment. However, if you are an investor who uses debt as a tool to gain wealth, it is important to understand this basic stress test associated with the Debt Service Coverage Ratio, as well as being aware of the challenges associated with rising interest rates and plateauing values.

100% Leased - But At What Cost?

By Venture Mortgage Corporation

We all realize-  at least on a basic level- that a commercial building is only as good as the rents it can produce. One of the main components of obtaining financing for commercial space involves the analysis of the current rent roll (a rent roll is a list of tenants with the rent amounts and expiration date for each tenant).  Questions about the current vacancy, historic vacancy, current rent per square foot, average lease length, and lease rolling periods are a few of the basic concerns lenders have that will need to be addressed during the underwriting of a loan.

So, is it in your best interest to get open spaces leased, even if you have to discount the new tenant to fill it?

In many cases, probably not. Here's why: if a property currently has a vacancy of 20%, and the owner would like to get that rate down to 10%, it may seem prudent to lease at a discount to lower the vacancy rate. However, if you are currently leasing at $10/Square Foot, lowering your rate to, say, $6/SF in order to attract new tenants could cause your entire property to be viewed by lenders as having a market value of $6/SF, since many lenders will take the newest price per square foot as the "market" rent for the area and use that figure when underwriting the loan.

If you find yourself in a situation where you are considering lowering rents to fill space and are looking to refinance in the next 18 months or so, it is important to contact a seasoned mortgage banker as your partner to assist you with a personalized situation analysis. Venture Mortgage has over 25 years of experience in commercial real estate, and we are experts in helping you to leverage your property and increase wealth without causing harm to your property value. Additionally, we have close relationships with a wide network of lenders willing to lend in a variety of situations.
 
Here's the takeaway: make sure you keep in mind the overall impact of how you lease up that last bit of space, especially if you are looking to place financing in the near future.