How to Get a Commercial Real Estate Loan
We often have clients ask us how to get a commercial real estate loan. This is never a simple answer, as every property and business is unique; however, there are some common factors that a lender will consider for each deal.
Factors Considered for A CRE Loan
Lenders typically consider 3 main factors when considering a loan for a commercial property. These include the following:
- The Cash Flow (DSCR) of both the property and the business
- The Loan to Value of the property
- The Personal Finances of the borrower
Cash Flow (Debt Service Coverage Ratio)
As discussed briefly in Part I of this series (Structure of Commercial Real Estate Loans), the DSCR of a property is the property’s cash flow. This can be measured a few different ways, but the most common formula is “Net Operating Income/Loan Payments on the property = DSCR.”
In investment properties, the ability to pay back the loan is directly related to the monthly income that the property produces; hence, lenders consider this number a contributing factor to the strength of the loan. The Property DSCR is most often used in non-owner occupied properties (NOO) or ones with a limited percentage of owner-occupancy. Retail strip centers, multi-family units, and office buildings are all excellent examples of properties that would produce cash flow from the property itself, not from the business operations within the property.
However, these numbers can be quite different when it is solely an owner-occupied property. Owner-occupied (OO) properties require lenders to look at the Global DSCR.
Global DSCR relates to the cash flow derived from sources outside of the property’s direct cash flow – most often, the business operations. Industrial properties often have owner-occupants that are operating out of some or all of the property. No monthly rental income is being collected on these properties, therefore, there is no property DSCR to analyze.
Global DSCR looks at the operations of the business itself to determine if the cash flow produced from the business will be enough to satisfy the monthly mortgage payments. This will most likely include business tax returns, P&L statements, financial records, etc.
Oftentimes, this ends up being a combination of the two. Many business owners will take advantage of tax deductions and legal protection by forming an LLC or other entity that owns the real estate and “leases” it back to the business. While both the entity and the business are owned by the same person, each cash flow picture will be different. In this case, a lender would look at both the Property DSCR (cash flow from renting out the space) and the Global DSCR (cash flow from the business’s operations).
On average, OO properties require a DSCR of 1.20 – 1.25 or higher; NOO properties require a minimum DSCR of 1.25 – 1.35.
Pro Forma Cash Flow
While banks and lenders tend to shy away from lending based upon Pro Forma Cash Flow (projected cash flow), we still feel it important to mention. At times, this is a necessary method for a property’s DSCR figures. Keep in mind that with this method, a bank may withhold full credit for the figures, lending only on a percentage of the projected cash flow since these figures are only projections, not guarantees.
Loan to Value (LTV)
The loan to value ratio measures the debt in relation to the value of the property. This figure is produced when dividing the amount of the loan by the value of the property, expressed as a percentage. Lenders use this number to determine the maximum amount they will loan on a property. This varies based upon the type of loan, as well as whether it is an OO property or a NOO property.
The LTV maximum for a traditional bank loan on a property that is owner-occupied is typically around 75-80%. For a non-owner-occupied property, the maximum is 65-70% LTV.
An SBA loan for owner-occupied properties can have an LTV ratio as high as 90%; whereas, some hard money loans will be as low as 60% LTV.
Let’s take an industrial warehouse selling for $1,000,000 as an example. The property will be owner-occupied, and the mortgage will be a traditional portfolio term loan through a commercial bank.
Based upon the bank’s pre-determined ratios (75%-80% LTV for OO), they would be willing to finance the property for $750,000 to $800,000 (the difference depending much on the Global DSCR and financial strength of the borrower).
Loan to Cost (LTC) is another similar ratio considered in commercial real estate financing. This factor analyzes the actual cost of the project (for construction projects) or the cost of the property. Instead of factoring based upon the value of the property, this considers the cash put into the deal. Most often, lenders look for similar ratios on LTC as they do on LTV.
Borrower’s Personal Financials
Lastly, the personal financial state of the borrower and/or guarantor is an important factor in commercial real estate financing. In the end, this is the person responsible for the repayment of the debt. If their own financials are in disarray, the bank may question their ability to repay the loan if the business closes.
A bank or lending institution will want to see personal financial statements such as tax returns, bank statements, and assets owned. They’ll consider cash in reserve, debt-to-income (DTI) ratio, etc.
They will also look at the borrower’s creditworthiness. The borrower’s credit score will tell a story of past financial performance, whether good or bad. The higher the credit score, the better the chance of obtaining a loan with good terms.
Lenders also consider net worth an important factor for repayment strength. An individual’s net worth is equal to their assets minus liabilities. The more liquid the assets (can be quickly converted to cash or equivalent), the more favorable lenders view the borrower’s portfolio.
Conversely, the more liabilities for which a borrower is a guarantor, the less the strength of their position. If the borrower has other debts, a lender may be hesitant to take a risk on someone with numerous obligations to pay.
In the end, knowing how to get a commercial real estate loan is the first step towards achieving it. Being aware of the three factors banks use for analyzing a commercial loan, provides a strategic advantage as you seek commercial properties. Pay attention to the cash flow of the property, the cash flow of your business, the amount of cash you have available for a down payment (LTV determines your down payment requirement), and the order of your own personal finances.
Once you have those things in order, what’s the next step? Getting the loan! Below we’ve outlined what that process looks like.
The Process of a CRE Loan
A basic understanding of the process of commercial lending can be helpful for those just starting on this journey. Under normal circumstances, the commercial real estate loan process takes between 45-60 days. Each situation is different, and you may find that your financing journey does not include half of these steps or includes many more. But the following 7 steps are common in most commercial lending situations.
7 Steps of the CRE Loan Process:
1. Initial Contact – Whether on the phone, through email, or an in-person meeting, discuss the details of your project with the banker or lender. Are you looking to purchase for your own business use? Are you planning on leasing half to another user? Is this a value-add investment property?
The temptation here for some is to withhold information that they think may limit their chances of getting the loan. But that only serves to waste your time and the lender’s. Be upfront from the start, so you both know whether or not you should pursue this deal together.
In this discussion, the lender may give you an overview of the terms and structure you can expect from the loan.
2. Preliminary Package – The bank or lender will most likely ask you for a preliminary package of information. This will give them an initial snapshot of the property, your business, and your financial situation. If the project is not within their financing parameters, they want to know that before they spend costly time underwriting the loan.
Your commercial lender will give you a list of all they require, but the preliminary package may include some of the following info:
- The Purchase Agreement for the property
- Property DSCR (P&L of property)
- Other Property Info such as taxes, rent roll, leases, etc.
- Global DSCR (business cash flow if OO)
- Financials for the Borrower and Guarantor (tax returns, bank statements, personal financial statement, etc.)
3. Term Sheet (Letter of Interest) – After the bank has reviewed the preliminary package of information concerning both the property and the borrower, they will extend a term sheet or Letter of Interest (LOI) if they wish to proceed. This will outline the general terms of the loan, such as the borrower, guarantor, loan amount, term, amortization, interest rate, fees, etc. This is not a formal commitment for you or the lender, but it puts the deal in writing to see if you both are on the same page.
4. Signed Term Sheet – If you agree with the bank’s proposal (terms, rate, etc.), you will sign the term sheet and send it back to the bank. Again, this is not a locked contract; this simply indicates you both want to move forward with the next step.
5. Formal Underwriting – This next step usually takes the longest. The lender begins the underwriting process. During this step, they often require surprisingly detailed information. Stay patient and understand that this is all part of the process to ensure a solid financial situation for you both. This will take a few weeks, at the least.
6. Formal Commitment Letter – Once the loan is underwritten, the bank will submit the loan for approval and then issue a formal commitment letter with the general loan terms included. This is the actual commitment to lend. There are usually conditions that must be met prior to loan closing, such as the appraisal, environmental report, title insurance, etc. Make sure you have a quality commercial real estate broker working on your side during this process, as you don’t want to miss some of these important deadlines. A broker that understands the process can keep you on top of deadlines and fully updated on each step.
7. Closing – As long as all the conditions outlined in the commitment letter are met, you will make it to the closing table, sign the finalized documents, and the Deed of Trust will be recorded. The Title Insurance company will take care of the proper distribution of money, documents, etc. during closing.
To learn more about the structure of a commercial real estate loan, read Part I of this series. For more information about the different types of commercial real estate loans available, read Part III.
As always, if you have any questions for our team at Peak Commercial Properties, please call us at 719.227.9987.
Disclaimer: The information contained in this article is not intended to provide legal or financial advice. Please speak to a commercial banker or financial adviser for professional guidance.