One common misconception I see when I’m working with new investor clients is related to financing. Most people who are ready to invest in commercial real estate are usually somewhat familiar with the home loan process. That’s commonly because they might have bought a home or two in the last few years and they remember the mounds of paperwork that go with it. Although there are a select few similarities, getting a loan for a commercial property is a bit different.
First off, when you get a commercial loan for investment you have to qualify has a borrower. You have to have money in the bank as reserves, you have to have down payment funds set aside, you will get asked about your credit report and any assets and liabilities you have and so forth…However, there is one huge key difference. A residential appraiser values the property primarily based on other sold comparables. The primary key difference is that even though comparables are considered with a commercial appraisal, a commercial property is valued primarily off of the income it produces.
Let’s look at a property together shall we? Here we’re looking to buy an income property for $2M. This income property makes $150k NOI, or net operating income, after all expenses. On a side note, if you’re a little unfamiliar with what Net Operating Income is, you should check out my “Investing Terms Part 1” video and get acquainted with the terminology and how we come up with these numbers. Continuing on with our example, we know that based on a cap rate formula and with simple math we will make 7.5% on our money with no loan on the property. However, we plan on having a loan…the question is will the PROPERTY qualify?
Let’s presume that we check the rates and find out we can get a loan for 70% of the value at 7% interest, amortized over 25 years. With this we’ll have an annual debt service – or mortgage payment – of just about $119k. This brings our cash flow to just a bit over $31k/year giving us a 5.21% cash on cash return rate. Now this might be a completely satisfactory scenario to you as a buyer. However, the key difference you must be aware of is the Debt Coverage Ratio, or DCR. The DCR is basically a calculation of how much of your yearly mortgage payment is covered. For example, if you have a net income of $120k/year and a mortgage of $100k/yea, your DCR is $120,000 divided by $100,000, or 1.2. This means you can pay 120% of your mortgage after all expenses.
Now all this may seem fine to you. You’re buying this property because you plan on things running smoothly, and that that extra 20% after your mortgage is pure profit right!?? Well, here’s the thing about investments…they don’t always work out perfectly, and banks know this. So for the bank to protect itself, it might set a HIGHER DCR for you to achieve. This way, if something happens and your income property isn’t making as much money as you thought, the bank is still covered. Perhaps instead of that 1.2 DCR the bank wants 1.3. This means that that the property has to make an additional $10k/year in order to work out for the bank loan. Of course, you could always pay less for the property, but for simplicity sake we’re trying to keep the numbers simple.
Going back to our $2m property example. We have an income of $150k before deducting about $119k/year for mortgage. $150k divided by our mortgage gives us a DCR of 1.26. During our talks with the bank, we find out that a 1.26 DCR is unacceptable. Instead, they want at least a 1.35.
Now there’s a few ways to go about this. The first being you put a larger down payment on the property. With another 5% down we can surpass the banks requirements and attain a 1.36 DCR. Also we could pay less for the property. The last two options would be to either get a lower interest rate, or a longer amortization schedule.
The DCR is definitely the key difference between a commercial investment loan and a home loan. However, there is still one other major difference…and that is the loan term. Most people who have bought a home are familiar with the 30 year fixed concept. You lock in your interest rate for 30 years and your payment will never increase.
However, commercial loans can vary. Because commercial properties are usually much, much higher in value than a home loan, the bank doesn’t want to set an interest rate for 30 years…they’ll miss out on too much money! What they do instead, is they have a much shorter time frame. Anywhere from 3 to 10 years. Now, they might AMORTIZE the loan over 25 or 30 years, but the rate they give you is NOT SET for that long. You usually get a lower rate for a 3 year “lock in” rate, meaning for the first 3 years they cannot change the interest rate. Then you pay a little more for 5 years, 7 years, and if available 10 years. This again is when you really need to sit down and figure out what your future investment plans for the property are. So what happens after this 3 or 5 or 7 year time frame?
Well, 1 of two things happens. The first one is that after your “lock in” time frame, the interest rate on the loan begins to “float”. What that means is that the rate can go up or down depending on the market. Of course, the bank can’t just make this up, they tell you in advance. They will usually say something such as “Your new rate will be adjusted every month based on the 10 year Treasure Bill + our profit yield of 3%, with a maximum ceiling of 12%”. This means that whatever rate the 10 year Treasure bill is at, add 3% to that and this will be your new interest rate. However, the interest rate they charge you can never go over 12%. I go over this a bit more in my “Where are Mortgage Rates Headed?” video.
The second thing that can happen is that after your “lock in” time frame you will have a balloon payment. A balloon payment is a large lump sum of the remaining balance you owe that you have to pay the bank. So if you have a 5 year “lock in” time frame with a balloon payment at the end, you have to pay the bank ALL of the remaining principle at the end of the 5th year, or the bank will foreclose on your property.
Now, this might sound a little intense when you first look at it…but realize that this is why commercial property is always being refinanced and sold so frequently – to satisfy these debts before they either float and go up or before the owner has to pay back a huge lump sum. Again, this is why investing is considered advanced and a game plan needs to be laid out.
Lastly, there’s one key additional factor that comes into play when you are attempting to get a commercial loan, and that is the tenant leases. If you have an apartment, most leases are 1 year, so it may not have as large of an impact as say a retail or office property. For example…If you have four different tenants in a retail strip center, but they are all small mom & pop shops on a one or two year lease, lenders may be a bit hesitant. Compare that scenario to having four different, multinational tenants such as a Baskin Robbins or Sprint store on a 7 or 10 year lease, and banks would feel MUCH more comfortable with the latter. The reason is because the chances of a large company like Baskin Robins or Sprint going bankrupt is much LESS LIKELY than a smaller mom & pop store…It’s not to say it’s impossible to get a loan with smaller stores, it’s just much more difficult and it usually requires more down payment and a stronger buyer.
When you are finally ready to start the commercial loan process, be sure to check with your lender or bank and see what is the common DCR range for the type of property you are thinking about buying. Also, be prepared for the TYPE of loan they give offer you – be it one with a balloon payment or one with a floating interest rate. You might not find the balloon payment as desirable as a floating interest rate, but what if the balloon payment bank offers you a much better rate for a longer period of time?? …again, being prepared from the start is the best way for you to ensure make the most of your investment …now that’s good to know. 🙂
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