Basics of Commercial Real Estate Financing
Original content by Kevin Kwan, Senior Loan Advisor
Hey all, I thought I'd do a primer on the basics of commercial real estate financing since there doesn't seem to be much attention towards CRE. There's a lot of subjects in this field, so I might add more segments later.
CRE is an incredibly broad term since it can cover anything from your standard apartment to a special purpose building like a movie theatre. But, since my background is brokering financing for apartments in the bay area (although I'm not restricted to financing CA), I will be focused on apartments (5+ units). I work with middle market investors on stabilized deals, so my post will reflect as such.
Required Terms to Know:
Net operating income (NOI): Net income, not including mortgage payments.
Debt service coverage ratio (DSC or DSCR): Basically the CRE version of DTI. We take the net operating income and divide it by the annual mortgage payment. It determines how much of a "buffer" or margin of income there is above the mortgage payment. It's how we know if the property is underwater or not.
Loan to value (LTV): Percentage of the property value or purchase price that is financed
Cap Rate: NOI divided by the property value or purchase price. Basically it tells you the return or yield of your investment. This is primarily how we communicate value in CRE.
There are a lot of differences between SFR (residential) financing and multifamily financing, and the best place to start is the most common question I get asked by novice investors: can I get 80% LTV (or 20% down payment)?
The answer is most likely no. Conventional loans are underwritten based on income on the property (see general guidelines below) as opposed to personal income. The first criteria to determining the loan amount is qualifying the property based on debt service coverage ratio (DSC or DSCR). This required ratio is generally 1.20x-1.25x. What does that mean? It means that the net operating income (NOI) must be 20-25% higher than the annual mortgage payment. That is the buffer of income the property has before it goes underwater. In smaller markets or tertiary markets, DSC will a bit higher, typically 1.30x. This means the property must have 30% more net operating income than the annual mortgage payment, which will limit the loan amount.
Once the loan amount is determined by DSC, we meet our first nuance to CRE financing, the max LTV limit. The property may have incredible cash flow that allows for a large loan amount, but lenders have a hard limit on the percentage of the property that will be financed. In low cap markets (think "expensive" markets like the bay area), we will have a hard limit of 75% LTV. I want to reiterate that 75% LTV is incredibly RARE in low cap markets, and there's usually an underlying reason for it that will make financing difficult (property not in great shape, tenant issues, etc.) In tertiary markets or small markets (like Stockton in CA or a small town with a MSA of less than 50k people), this limit will be 60-65% LTV (35-40% LTV).
Remember when I mentioned that 80% financing (20% down) isn't possible in multifamily financing? The exception to that rule is a bridge or construction loan. However, unless you have proven track record for stabilizing properties and you have a budget and plan outlined for improving the property to the point where it can take the loan out after the 12-24 month window, it’s not possible. This brings me to another to the next nuance in multifamily financing, borrower experience. This one matters a lot. In fact, banks will ask you for a resume or bio regarding your real estate experience. It doesn’t need to be detailed , but the banks want to feel comfortable that when they lend out that $1MM loan, the borrower knows what they’re doing. If they find a lack of experience, one solution that banks will require is a third party management for at least 1 year. Even if you have experience in multifamily overall, lenders will want you to have experience in the same MSA or market as the property you’re purchasing. So, if you own a lot of multifamily properties in Oakland, and you want to buy an apartment in Idaho, lenders will require a third party management company.
So far, you may have the impression that multifamily financing is entirely based on the subject property, but here is yet another nuance, borrower financials. While we don’t pay as much attention to personal income (a lot of my clients are retired), we care greatly about their overall cash flow. And a few big contributors can be personal income, real estate income, and other investment income. So, we look at the big picture. Lenders will want to know if you’re overall cash flowing. If you’re struggling to make your debt payments, then financing will be challenging. And as with SFR financing, if you have credit issues, then that may be a problem down the line as well. In addition to having a positive cash flow, lenders want to know that you have liquidity (cash reserves) after the purchase. At a bare minimum, lenders will want you to have at least 6-12 month of cash reserve, but please note that lenders will usually have higher requirements, especially with a lot of tenants not making payments due to COVID 19 crisis.
Now, you’ve made it pretty far. You’ve learned that the loan amount is determined by criteria such as DSC and LTV. And you’ve learned that financing depends greatly on the borrower as well. A smaller, but significant nuance is that lenders like to work on loan amounts of $1MM or more. This does not mean that the property will automatically qualify for $1MM, it simply means that properties that can cash flow at least $1MM will generate more interest from lenders. The primary reason is that banks earn more interest on larger loans than they do with smaller loans. And it’s more efficient for them to work on the big loans versus the smaller loans given all the work involved in underwriting a multifamily loan.
There are WAY more nuances than what I have typed up so far, but this should begin to cover the basics. Here are rough underwriting guidelines:
DSC requirement: 1.20-1.25x for top markets; 1.30x for smaller or tertiary markets
Max LTV: 75% for top markets; 60-65% for smaller or tertiary markets
Fixed Loan Term: 5, 7, and 10 year fixed typically (30 year fixed loans are rare, institutional products like HUD or life company loans), rolls to adjustable after fixed term typically.
Term: Usually 30 years
Amortization: 30 years. Some local community or business banks and credit unions may offer less.
Prepays: Varies greatly, but just about every loan with a few exceptions have prepays. Although if you plan to sell, the lender may allow for an assumption for a 1% fee.
Recourse: Non-recourse available, but higher leverage or certain risk factors to the property can mean recourse only
Now that you’ve learned the barriers to entry on financing multifamily properties, my biggest suggestion for beginners is to partner up with someone who is financially strong and experienced, and preferably vest the property within a LLC or LP, and make the partner a managing member/general partner.
In my opinion, the best beginner multifamily property is a stabilized 6-10 unit apartment within the market you reside in. Hopefully, it cash flows enough to allow for a $1MM loan, which will present more options for financing. I wouldn’t try to pursue “value add” properties. There’s usually issues that may present a financing challenge.
Properties to avoid as a beginner:
SRO’s (think studios without a kitchen or bathroom) – Although they may be a high cap property (great returns), many lenders will not lend on multifamily properties without a kitchen or bathroom in each unit. Plus, they are often not in great condition (have reputation for being slums).
Mixed Use (ie 6 residential units over 2 commercial bottom floor) – Financing for mixed use properties are even more nuanced than multifamily properties. Rule of thumb is that if the income from the commercial space exceeds 20% of the overall income from the property, then it is underwritten as commercial. Please note that a lot of lenders will NOT include income from billboards or cell towers.
Senior Living Facilities (aka nursing facilities) – I’m pretty tempted to lump this in with properties to avoid at all cost. But facilities like this typically have thin margins and high turnovers. It requires someone who is experienced in this field to handle it. Please not that age restricted apartments are fine. I’m referring to facilities that require advanced nursing care such as convalescent homes.
Hotels/motels – Financing is challenging for these assets due to the vacancy rate. Please note that Airbnb income does NOT count towards property income. Airbnb units counts as vacant units (yes, I’ve been asked this). And no, SFR (1-4 units) with Airbnb income doesn’t qualify for hotel loans, even though the operations are similar.
Vacant apartments or Apartments with non-paying tenants – Non-paying tenants count as vacancies. Vacancies mean no income. No income means no loan. This is usually where bridge loans come in.
Properties to AVOID AT ALL COST!
Broken condos (you own some of the condos within the HOA, but not all) – Banks generally don’t like HOA’s. They are a challenge if the bank has to foreclose on them. We can finance condos only if the owner acquires the entire complex (not just 32 condos out of 40 total condos within the HOA , for example)
Anything with cannabis (even if it’s a research lab) – It’s not legal on the federal level, so banks won’t finance it. I have private money lenders that may finance it, but it’s not cheap
Anything controversial – Strip clubs, for example. There are some banks that don’t care about the reputation for financing properties like this, but most banks do.
Anything with environmental problems (ie gas station) – Seriously, please avoid this if you want to finance the property. Banks typically won’t finance them. Phase 2’s and remediation is neither fun nor cheap.
Master leased apartments - Lenders generally don't like the structure because it presents a potential problem if the lessee doesn't manage the apartment well.
