Commercial real estate (CRE) is one of the more lucrative investments a person can make. These income-producing properties offer numerous advantages over residential investments, as they can be a dominant source for not only building wealth, but generating monthly cash flow. It is worth noting, however, that building wealth in commercial real estate doesn’t start with the first rent check, but rather the commercial real estate loans used to fund respective deals. If for nothing else, the commercial real estate financing structure used to fund an acquisition will set the tone for the entire exit strategy.
In order to understand how to invest in commercial real estate, one must first grasp the various types of commercial real estate. These properties are generally used for business purposes, with owners leasing the occupied space for monthly rent. Commercial real estate generally consists of the following property types:
The most popular type of commercial real estate is office space. These buildings, which can range from single-tenant offices to skyscrapers, are defined by one of three categories: Class A, Class B, or Class C.
Another popular type of commercial real estate is retail buildings. These properties, which range from strip malls and community retail centers to banks and restaurants, are often located in urban areas. The size of these real estate properties can extend anywhere from 5,000 square feet to 350,000 square feet.
From warehouses to large manufacturing sites, industrial buildings are typically geared towards manufacturing industries, as they offer spaces with height specifications and docking availability. In addition, these commercial properties generally lend themselves more to investment opportunities.
These commercial properties are made up of apartment “four-plexes,” high-rise condominium units and smaller multi-family units, which can range from four to 100 units. Unlike other commercial real estate, the lease terms on multi-family buildings are typically shorter than office and retail properties.
Unlike the above mentioned properties, special purpose commercial real estate properties are constructed by the investor. They typically consist of car washes, self-storage facilities and even churches.
Because the best commercial real estate properties are in high demand, it’s critical for investors to focus on location, future development and improvements. This is not only how commercial properties gain value, but also appreciate.
The idea of obtaining commercial real estate financing may seem intimidating at first, but investors who spend the time learning about the process and the different types of commercial real estate loans will find that they are completely attainable. Below are the main steps involved in obtaining a commercial investment property loan:
The initial step is to determining whether to finance a commercial property as an individual, or an entity. Although the majority of commercial real estate is purchased by business entities such as corporations, developers and business partnerships, it can easily be completed as an individual investor. The lender essentially wants to make certain the borrower can repay the loan, thus requiring borrowers to provide financial track records in order to secure a loan. For newer businesses with no credit history, the lender will typically require the investor(s) to guarantee the loan.
It is important for investors to recognize residential and commercial mortgages are not the same. First, unlike residential mortgages, commercial loans are not backed by government agencies such as Freddie Mac and Fannie Mae — and will typically charge higher interest rates than comparable home loans. Secondly, terms of commercial loans differ from residential ones. Commercial loans range from five to 20 years, whereas residential loans will typically range from 15, 25 and 30 years. As an investor, the majority of this will be based on your financial and credit history.
An important metric lenders consider when financing commercial real estate is loan-to-value ratios (LTV). This figure measures the value of a loan against the value of the property, and is calculated by dividing the amount of the loan by the property’s appraisal value or purchase price. For commercial loans, the LTV will range from 65 percent to 80 percent, with lower LTVs qualifying for more favorable financing rates.
Lenders also look at debt-service coverage ratio (DSCR). In essence, this measures a property’s ability to service a debt, and it compares a property’s annual net operating income to its annual mortgage debt service, including principal and interest. A DSCR of less than one percent reveals a negative cash flow, and commercial lenders generally look for DSCRs of at least 1.25 to ensure proper cash flow.
Before financing a commercial property, investors need to consider all aspects of the process: loan-to-value ratio, debt-service coverage and creditworthiness. Additionally, a proper business plan will help investors, especially beginner investors, to streamline the financing process.
There are a wide range of commercial investment loan types, and it is up to the investor to decide which financing option best fits their needs. Each type of loan has unique eligibility requirements, such as a minimum credit score, experience level and down payment requirement. These loans also have varying terms to pay attention to, including the loan term, interest rate, and loan-to-value (LTV) ratio. For example, one investor may be in search of a loan that offers lower interest rates over a longer loan term, while another investor’s priority might be finding a short-term loan as a means of bridging a financial gap. For a better idea of which commercial real estate loans may meet your own needs, please reference the following:
The U.S. Small Business Administration offers several loans under the 7(a) umbrella, each of which are designed to provide financial assistance for small businesses. Investors looking for commercial real estate loans should carefully consider which of the following 7(a) Loans will work best for their next project:
The 504 Loan Program is another SBA product made available through Certified Development Companies (CDC). These loans are specifically intended to stimulate business growth and job creation by offering small businesses yet another financing avenue. More specifically, however, the “504 Loan Program provides approved small businesses with long-term, fixed-rate financing used to acquire fixed assets for expansion or modernization,” according to the SBA.
The Small Business Administration’s 504 Loans can’t exceed $5 million, and are specifically designated for fixed asses, including:
Otherwise known as traditional loans, conventional commercial real estate loans are those issued by banks or lending institutions. Consequently, conventional commercial real estate loans are not backed by the federal government. Often used to purchase and finance assets like owner-occupied office buildings, retail centers, shopping centers, and industrial warehouses, conventional loans have developed a reputation for some of today’s most widely used commercial real estate loans.
A traditional commercial property loan typically finances anywhere from 65% — 85% of an asset’s loan-to-value ratio. As a result, borrowers will often be expected to cover anywhere from 15% — 35% of the property’s fair market value. That said, there is usually no loan maximum. Borrowers can, however, expect commercial real estate loan terms to last anywhere from 5 — 20 years, with payments fully amortized over the loan’s duration. While conventional loans tend to come with lower fees, they are often harder to receive approval for.
As their names suggest, commercial bridge loans represent a temporary loan option for investors to exercise—one that bridges the gap—until refinancing becomes available to make the switch to a longer-term loan. Typically offered by institutionalized lenders, commercial bridge loans award many borrowers the ability to compete with all-cash buyers. Since commercial bridge loans usually finance up to 90% of a property’s LTV, those who can’t use cash should find it easier to get their foot in the commercial real estate sector. Since bridge loans are short-term, they don’t tend to last longer than three years. Therefore, borrowers should expect to refinance to a long-term loan sometime in the near future.
A hard money loan is made available to commercial investors by organized semi-institutionalized lenders. More importantly, however, hard money lenders are typically licensed to lend to real estate investors and specialize in short-term high-rate loans with fees that award many investors the chance to buy commercial real estate that wouldn’t be able to otherwise.
In return for roughly 60% — 75% of the asset’s after repair value (ARV), hard money lenders will require interest fees upwards of 15%, in addition to about four points (another upfront percentage fee based on the loan amount). While hard money lender fees are sometimes as much as four times the amount of traditional lenders, they may be well worth the cost of admission for short-term loans. Not only is funding granted within a few days (as opposed to months with traditional lenders), but it can be a lot easier to receive approval for. If for nothing else, hard money loans are asset based, meaning the lender makes a decision based on the subject property, and not entirely on the borrower.
Otherwise known as commercial mortgage backed securities (CMBS), conduit loans are commercial real estate loans secured by a first-position mortgage on a commercial property. Traditionally offered to borrowers through commercial banks, conduit loans offer borrowers a fixed-interest rate over the course of about 25 — 30 years. It is important to note, however, that conduit loans will require a balloon payment at the end of the term. Thanks, in large part, to their relative flexibility, conduit loans allow many commercial real estate investors to qualify for a loan that typically wouldn’t.
The majority of commercial real estate is purchased with the sole intent of generating ongoing income, otherwise known as cash flow. They are made up primarily of tenants who rent individual units through a lease agreement. However, in many cases investors will purchase commercial real estate with the intent of utilizing the building for their own purposes. This is known as Owner-Occupied Commercial Real Estate (OOCRE).
In general, owner-occupied commercial real estate is based on two conditions: the owner’s occupancy percentage of the property or the amount of rent paid by the owner. In addition, OOCRE loans are completely different than non-owner occupied loans, and lenders require different qualification. For one, lenders will look at the primary source of repayment for the OOCRE loan. This is driven predominantly by the debt-service coverage of the borrower, which is typically determined by business earnings before interest and taxes.
In order to truly understand how to invest in commercial real estate, investors need to fully comprehend the financial components that go along with it. Commercial real estate loans are nothing short of instrumental in the success or failure of a particular exit strategy. Therefore, take the time to review the commercial real estate financing process before making the leap, including the various loans made available to you.
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