Buying Your First (Or Your 50th) Commercial Property

At some point, practically every residential real estate investor comes across a multi-family or other commercial project that seems like a deal. Commercial mortgages, while sharing some common characteristics, are significantly different than residential mortgages. The short time you invest in reviewing these differences will help you know what to expect as you go through the process of securing commercial financing through a national or regional bank.

The Similarities

With both commercial and real estate loans, the borrower has to provide a complete and accurate residential loan application (called form 1003), have their credit report pulled, and provide data and proof regarding income streams. Are you self-employed or W2 employee? How long? Typically, three years tax returns—all schedules for personal and business—will need to accompany the file for pre-approval and/or underwriting.

Lenders also want to know about available liquid assets. Are there seasoned funds (deposited for more than 3 months in an institution) for the down payment, application fees and closing/settlement costs? Do you have at least three months (sometimes up to six months is required) of reserves remaining after the close of escrow?

The Differences: Debt to Income Ratio vs. Debt Service Coverage Ratio

The Debt to Income Ratio (DTI) is a calculation of how much of the borrower’s monthly gross income is used to pay creditors—this ratio plays a large role in loan approvals with residential mortgages. It’s very difficult to get an A-paper loan (best rates) if borrowers use more than 45% of gross income to pay their household debt load including mortgages, credit cards and installment loans. Go outside the well-defined parameters without strong compensating factors and you’ll likely have to look at non-prime lenders.

For commercial transactions, this ratio is never even reviewed—the loan becomes all about the property, the tenants, the history and the Debt Service Coverage Ratio.

The DCR

In Commercial Financing, the all important number is the debt service coverage ratio (DCR). DCR is calculated by taking the new loan (principal and interest) and dividing it into Net Operating Income of the Property:

  • = Net Operating Income
  • Total Debt Service

For residential multi-family loans, this ratio must be 1.20 or higher. For properties used for other purposes, you may need the ratio to be 1.25 or higher (offices, manufacturing, warehouse, medical), each niche of the market has its own accepted or required DCR.

One transaction that I’m currently working on is the refinance of an office building in New York. It has a triple-net lease, meaning that the lessee is responsible for practically all expenses including taxes, maintenance, and insurance. Net operating income per year is $152,000. The loan they’re requesting is for $1.3 million on a 10-yr ARM (amortized over 30 years) at a rate of 6.875%, and so their ratios look like this:

  • = $152,000
  • $102,481
  • = 1.55

As you can imagine, lenders are tripping over themselves to get to this property, because the ratio required is 1.25 DCR. It the appraisal comes in then this deal is a slam dunk!

A DCR of less than 1.0 would mean a negative cash flow. A DCR of say .95 would mean that there is only enough net operating income to cover 95% of annual debt payments. For example, in the context of personal finance, this would mean the borrower would have to delve into their personal funds every month to keep the project afloat. Generally, lenders frown on a negative cash flow which is why the ratios are set where they are. However, some lenders may allow it if the borrower has strong outside income. Remember though, that the borrower will be penalized with higher interest rates, higher fees or more expensive pre-payment penalties. Any compensating factor that increased the risk to the lender results in penalties to the borrower in some form.

Speaking of pre-payment penalties, almost all commercial loans are going to have a pre-payment penalty commiserate with the length of the fixed period of the loan. To optimize the DCR, borrowers typically look at 3-, 5-, 7-, and 10-yr adjustable mortgages. If a borrower opted for a 5 year ARM, the pre-payment penalty would be something like 5-4-3-2-1, meaning that if the property sold or refinanced in the first year, the penalty paid to the lender in principal added to the payoff would be 5%. In year five, it would be 1%.

Due to the stiff penalties, most loans are assumable as long as the new borrower qualifies.

What about the property?

Lenders want to know everything they can about the subject property. What is the space used for? What is the rental history like, i.e. has the space had greater than 85% occupancy in the last two years? How much time is left on the lease(s)?

With the cooperation of the seller, borrowers need to get access to the last two years financial statements including all expenses, a current rent roll, copies of leases, and a breakdown of any capital improvements to the property including costs associated with repairs, maintenance and rehabilitation.

About 50% of lenders request a resume of the buyers. They want to know about the background, experience and length of time that the borrower has managed or invested in real estate.

Most require a one-page financial statement from borrowers—and it doesn’t hurt if that document is prepared by a third party: CPA, financial planner, personal banker, etc.

Here’s a summary list of list of items you can expect to have for a commercial transaction pre-approval, although the list isn’t all-inclusive:

  • 1. Residential Loan Application (1003)
  • 2. Credit Report
  • 3. Employment Information including a resume
  • 4. Assets, usually last three months financial statements, all pages front and back
  • 5. Last three years personal and business taxes, all schedules, all pages
  • 6. Schedule of Real Estate Owned
  • 7. Copy of Purchase Contract
  • 8. Last Two Full Year’s Financial Data on Property and Current Year To Date Profit and Loss
  • 9. Current Rent Roll
  • 10. Preliminary Title Commitment from Escrow/Title Company
  • 11. 5 color photos of the property (view from N, S, E, W and one street view)

Note: Full documentation and stated income commercial loans exist, but as with residential loans, bear in mind that the more you show, the better the interest rate and terms on the transaction

The Process

After mortgage brokers receive the package from the prospective buyers, we create an Executive Summary that condenses your loan request into about 2 pages. We then shop that package to our database of lenders, paying special attention to those that are specialists in your niche or are particularly strong with borrowers matching your risk profile.

Once the bank with the best terms is selected and they receive the full package of documentation, they will calculate the spread of the property, meaning they will work all numbers to be able to make an official offer.

At that point, they issue an official Letter of Interest (LOI) and require an up front free from the borrower (usually $2500 to $5000 depending on the amount financed) to proceed with ordering the appraisal and required environmental due diligence. From start to finish, this process takes about 45 to 60 days, depending on the appraisal.

One thing to remember, the rate on commercial deals isn’t locked until about three days prior to close of escrow, so you are subject to market conditions during the application, processing, and underwriting process until final loan docs are drawn.

Commercial Financing with Morgan Capital of Arizona, Inc.

In addition to world class rates on residential mortgage products, Morgan Capital of Arizona, Inc. also has the capability of putting together very competitive commercial loan programs for our clients.

There are too many commercial categories to list, but our lending partners are particularly strong with multi-family properties, office space, retail, and warehouse properties. Practically any commercial scenario can be financed through our network of lenders and is available in any state.

For questions and information on commercial financing scenarios, please don’t hesitate to call:

Other Financing

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