Understanding Commercial Financing - "You can't play if you
don't know the Game."
Welcome to the world of
commercial mortgages. This booklet is written to the individual
who is venturing out into the world of commercial investment.
It is written to introduce you to some of the differences
between residential loans and commercial loans and hopefully
help you to be more profitable in your quest for diversifying
your income through commercial properties. I will endeavor to
teach you the who, what, and why of commercial loans. A big
part of your success as a commercial investor is in choosing the
right mortgage for the property so it just makes sense to learn
about commercial mortgages. What follows is the straight scoop
on commercial mortgages. Knowledge is power; my goal is to give
you that knowledge - accurate knowledge. Therefore, let us
begin.
WHO?
ho lends the money in the
commercial realm? This is the first and possibly most important
difference between commercial and residential. Yes, you apply
to a large lender or bank or some financial institution whenever
you do a residential loan. However, the money is not really
lent by that institution. It is for a few days. Ultimately,
they sell the loan to FNMA or FHLMC and are reimbursed the
money. They just keep the servicing rights. Fannie or Freddie
then bundle all those loans and pass them through to investors
as mortgage-backed securities. In other words, the bank is not
really lending their own money. It is not that way in
commercial. In the commercial realm, most loans are done by
banks and it is their own money. They take the money on
deposit with them and loan it out to different companies. There
is no giant like FNMA waiting to reimburse them. If that loan
goes into default, then the bank is stuck unless they can sell
the property for a profit. Because of this, they are much
pickier than they would be on residential loans.
But that is not all. 80% of
all businesses fail within 2 years and if someone does fall into
financial difficulty, then they will let their commercial
investment go before the house that their wife and kids live
in. Commercial loans are investment loans and you know the
rules are stricter on investment loans. Because each piece of
property is completely different, commercial deals are not hard
and fast. No standard qualifying ratios here. The property is
more important then the borrower. You can have an excellent
borrower but have a bad property and no one will buy the loan.
I had a CPA call me mad as anything that our underwriter denied
his client’s loan. His message was something like this, "I have
a guy with perfect credit, great income, a property worth
$450,000 and all he wants is a little cash out loan of
$300,000. You must be an idiot if you can not get this loan
done."
Therefore, I pulled the
loan, and much of what he said was true. The borrower’s credit
was perfect and his income was good, except on the property.
The property itself was losing money. His borrower told him the
property was worth $450,000 but based on the cash flow, it would
not appraise for more than $150,000(more on appraisals later).
No one is going to loan $300,000 on a place only worth $150,000!
In talking to him, it turns out he has been trying to get it
approved for over a year! Commercial loans are deal specific.
All deals are considered on their individual merits, not on some
arbitrary formula.
The good news is that if the
deal is good, there is more than enough commercial money
available. Non-bank lenders such as insurance companies and Wall
Street portfolio lenders WANT to lend and since they are not
banks, they have different guidelines. Generally, they will
give you longer terms and occasionally lower rates. A great
commercial broker can bring these other lenders to your deal.
WHAT?
hat takes commercial deals
so much longer than residential loans to close? Rare is the
commercial loan that closes in less than one month and the rates
for those quick-close deals are much higher. Small commercial
loans will usually take 2 months and large commercial loans can
take as much as 4-6 months or more! Many factors go into this -
the appraisal, the broker themselves, the title, and especially
the borrower. Let us start with an appraisal. It will rarely
be ordered before the loan is approved and the borrower has
committed. This could be weeks into the deal. Once ordered, an
appraisal on a commercial property will often take a month and
it could be longer if the property is large and has mixed use.
That is because the land under the commercial property is just
one part of the equation. The properties value ultimately will
be determined by its’ cash flow. The appraiser of a commercial
property has to get the financials on the property and compare
it to similar properties in the area. If my apartment complex
is 80% rented and the average complex in the area is 85% rented
it will effect my appraisal. How the property has been managed
is important. How quickly the appraiser can get that
information is important. The appraiser often must contact an
owner and get information direct from them. It is not as easy
as pulling up an MLS listing. Do not trust someone who says
they can turn a commercial appraisal in less then a week like a
residential appraisal. That person does not understand
commercial.
You must be careful in
choosing a broker or banker to help you. A broker often can
drag the file because they do not get the information needed up
front. If my apartment complex is running 30% vacant compared
to most places running 25% vacant then I need to explain that
and have a business plan ready that explains how I am going to
change that. Most brokers will send a deal in with a
residential loan application filled in, a credit report and two
years tax returns and think the loan can be approved. Then when
asked for the stuff that is really needed-3 years operating
statements, business plan for the property, etc. they balk at
getting it. The loan will never be approved just based on 2
years tax returns and a credit report. Why? Because the
property is the most important factor in commercial
underwriting. If you get the right documents in a timely
fashion, however, then your loan will move through much quicker
and actually have a chance of being approved. Title insurance
on commercial property often involves such things as
environmental and zoning issues, which can take 30 days as
well. One $10 Million dollar deal was hung up on environmental
issues for 3 months! The more complete the information up
front-the quicker you can close.
Finally, the other big drag
on commercial closing times is the borrower - and I do not just
mean dragging on getting documentation. It is important to
remember time constraints, if you are under contract, you have
45 days of underwriting and appraisal time from the time you
stop shopping, provide everything, and commit to a lender. You
CANNOT SHOP A COMMERCIAL LOAN UNTIL THERE ARE JUST 30 DAYS
LEFT! If you do, you will end up with a high rate, quick close
loan, or asking for an extension and risking losing the entire
property if the seller got another offer. It is not worth
losing out on a property that will yield you thousands of
dollars of profits in a month over 1/8th percent in
rate, which may mean $50 a month saved! Do not be penny wise
and pound foolish. Understand the time constraints and operate
appropriately.
WHY?
HY invest in commercial real
estate then? If the loan criteria are tougher, and the deals
take longer to close - why not just stick with residential
investing? Because, commercial properties are much lower
maintenance properly managed. You can rent them out triple net
lease and have the customers make all the repairs. You are
typically dealing with a large building built very well and not
a house with kids. These properties are not used like a
residential house-people do not live there and so the life of
the property is extended. And even if you are dealing with a
multi-family property where people are living, you have
diversified revenue. One apartment complex may have 20 units in
it and so if one renter moves out you still have 19 other rents
coming in. The commercial mortgage is actually your best friend
because we take into account vacancy rates when underwriting the
file and make sure that the property still cash flows EVEN with
average vacancy rates for the area. You KNOW your return on
investment (ROI) going in and the risk is mitigated. MOREOVER,
you get all the normal benefits of investing in Real Estate:
appreciation, but you get to depreciate the asset on your
returns, steady money with minimal effort, and a hedge against
inflation that is tough to beat.
Commercial real estate
investing can be lucrative. If you are a business owner, buying
a property and fixing your payments instead of paying rents that
escalate yearly is a smart move. Either way, commercial real
estate is a smart choice. Making the right choice on your
mortgage can make all the difference between a good investment
and a great investment. I hope this helps clarify commercial
mortgages a bit, for more information or assistance, please feel free to
send us an email at
info@castlecommercialcapital.com or call us at
248-351-2654.
Wishing
you a prosperous year,
Malcolm
Turner, President and CEO
Castle Commercial Capital, LLC
