Financing is critical to the healthy functioning of the commercial real estate market.
Occasionally, that long hoped for cash buyer with a suitcase full of money comes along and scoops something up, but, by and large, most commercial sales in our market are financed.
While deals can fall apart for all kinds of reasons, a common reason is due to a buyer being unable to obtain suitable financing. While established buyers know what to expect on the path from contract execution, to the bank, and then to the closing table, many sales are to first-time commercial buyers.
Let’s cover some basics and best practices for those new to the commercial real estate loan process.
A pay stub and good credit aren’t enough. Banks must qualify both the borrower and the property and will commonly refer to the 5 Cs of Credit, which consist of the following:
• Capacity—How will the borrower repay? Does the property’s net income support loan payment?
• Capital—Does the borrower have any skin in the game?
• Collateral—How is the deal secured?
• Conditions—How could market conditions impact the borrower’s ability to repay?
• Character— What is the borrower’s trustworthiness to repay?
For owner-occupied properties, the underwriting emphasis will be more on the strength of the borrower and their track record while the property’s past and projected performance will be the focus for investments.
Generally, commercial loans have lower loan-to-value ratios compared with residential and very few little to no money down options. Interest rates cover a wide range but are higher on average. Instead of 15 to 30 years fixed, loan terms are most likely to be 3-, 5-, or 10-year with adjustable rates, balloon payments, and 15 to 25 year amortization. For small companies and LLCs created to buy real estate, banks will most likely want a recourse loan with a personal guarantee.
From the first lender meeting to closing, a residential mortgage could potentially be finalized in fewer than 30 days, while the commercial process is likely to be 45 to 90 days. The appraisal alone takes three to six weeks. Plan accordingly and give yourself enough time.
Banks almost always require an appraisal, which costs more and takes longer to complete than residential appraisals. These draw the most attention when they come in lower than the purchase price. Even then, the deal isn’t automatically dead, but the bank must decide if it still wants to offer financing and on what terms. Many times, if the bank still wants to close the deal, they will lend on the lower appraised value. At that point, the borrower has a few options: Produce the cash necessary to bridge the gap between the revised loan value and the purchase price. Offer additional collateral, such as another commercial property or personal residence. Renegotiate the purchase price with the seller, or, ask the seller to finance the gap. Consider second mortgages and other alternative financing options carefully. Finally, the option always exists to walk away from the deal.
Improving Your Deal’s Chances of Success
1) Go Meet A Few Bankers
Make the rounds early; don’t put a deal under contract and then go have your first meeting with a bank. Test the waters to see what kind of response your proposal receives. Most start where they do their primary banking, but be open to meeting with several bankers to find the right fit on a personal level and institutional level. Find a bank that provides clear and prompt feedback to loan requests. While loan programs and terms can and do vary between banks, there isn’t any one bank that beats everybody else all the time on all deal types.
2) Understand That Each Bank Has A Different Lending “Sweet Spot”
Based on the bank’s size (community, regional, or big bank), credit policy, risk tolerance, leadership, people, and past lending history, each bank has certain deal types that they gravitate to and that they do well. While there is certainly significant overlap across institutions, preferences for and aversions to different deals emerge and can vary based on property type (retail, industrial, office, apartment), use (owner-occupied vs. investment), borrower profile (company size, corporate vs. local) and deal size. A good loan officer will tell you early on whether or not a deal is in their wheelhouse as they don’t want to waste your time or theirs on something that ultimately won’t work.
3) Don’t Assume That One “No” Means The Deal Can’t Be Financed
If you hear “No” five or more times, that might be a sign to take a step back and reassess, but one “No” says very little about the viability of a deal.
4) Tell Your Story Well
Clearly communicate who you are, what you want to do, and why.
Prepare a packet with complete information about your ownership group (relevant experience, tax returns, financial statements) and all relevant property details (plats, plans, proformas). As a loan officer considers a prospective loan, they want to get comfortable with the fundamentals of the deal in their own mind while also anticipating issues that could be flagged by underwriting or brought up during loan committee. The deal narrative and supporting documentation helps everyone get up to speed quickly and reduces the number of question marks surrounding the deal. Telling your story well is important in many different contexts, but especially so when you are asking to be entrusted with large sums of money.
The benefit of being prepared is that you can proceed quickly and confidently when you are ready to move on a property. Buyers without a handle on their financing sources are forced to make weak offers that are bloated with long financing contingency periods. All else being equal, a cash offer beats a contingent offer and short contingencies beat long contingencies.
Your preparation will impact what type of offer you can make and, ultimately, might make the difference between your offer being accepted or rejected.
While the high net-worth individual investor with a proven track record and the well-established local company are sought after by every bank in town, and may be able to receive several competing term sheets on their latest deal just by picking up the phone, the rest of us can improve our chances of success by doing our homework, seeking out the best banking partner and being prepared when our turn arises.
By Billy Hansen