Commercial real estate offers investors an opportunity to diversify into other asset classes. Understanding the types of financing available to this sector is critical to making sound investments and achieving the desired returns. But why use leverage?
Debt financing allows investors needing more cash to pay for an investment fully. When interest rates are low and financial leverage is positive, debt increases the investor’s return on equity compared to if they purchased the investment all-cash.
Let’s first discuss the differences between residential and commercial financing. In residential loans, the lender considers the borrower’s credit score, income, and debt-to-income ratio, while in commercial loans, the lender focuses on the property’s income potential. Commercial real estate loans require a higher down payment, have shorter terms, and typically feature amortization periods ranging from 20 to 25 years, in contrast to the 30 years expected in residential loans.
In commercial real estate, there is an array of financing options depending on each client’s needs. The Small Business Administration (SBA) offers financing for owner-occupied real estate, which is ideal for those seeking to purchase the real estate where they operate their business. The SBA extends loans of up to $5.5 million to small businesses to acquire real estate assets. Also available are private lenders, who provide custom-made loans to suit each borrower’s needs. Generally, they have less strict lending criteria and can fund much faster than conventional loans, although they have higher interest rates than conventional loans.
Other types of loans include bridge loans, which help investors cover expenses between acquiring a property and securing long-term financing. Construction loans are available to fund the development of a project. This type of loan is typically converted into a permanent loan once construction is complete.
For most investors, regional banks are the most typical source of financing. These banks can offer different types of loans. Investors can also use a mortgage broker who has an array of lenders and can negotiate better terms and rates on their behalf.
When requesting a loan, lenders initiate an underwriting process. First, they ensure that the location and type of asset meet the lender’s parameters. The lenders will analyze the rents of the underlying assets, verifying that these rents are market rates and achievable. Sellers may present pro forma rents, which lenders typically do not consider, or income from short-term rentals, which are often more volatile.
During the underwriting of a loan, the lender examines two essential ratios: the Loan-to-Value (LTV) and the Debt-Service Coverage Ratio (DSCR). The DSCR ratio compares a property’s net income to the annual debt obligations, determining whether the property generates sufficient net operating income to cover loan payments.
In conclusion, the lender’s underwriting process comprehensively analyzes the deal, which greatly benefits the buyer, helping them understand the feasibility of the purchase.
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