Commercial vs. Residential Lending
When it comes to real estate, sales are broken up into the two following categories:
* Residential property: From a lender’s point of view, residential property is your personal residence, which is more than likely a single-family home. A property that contains two to four family dwelling units — duplexes, triplexes, or fourplexes — is also treated as residential.
* Commercial property: A commercial property, from a lender’s point of view, is a property that contains five or more family dwelling units. Under this category, you can have a 5-unit apartment building or a 100-unit apartment building (or anything in between!).
These are all considered commercial as well: office buildings, strip malls, warehouses, industrial buildings, mobile home parks, and raw land. A property that contains a mix of any number of residential units and commercial spaces is also considered commercial.
Obtaining a loan for a commercial property is similar to obtaining a loan for a residential property. For example, with both types of loans you have to apply for the loan and show that you have the capability of repaying the loan, you must be creditworthy, and you must provide a down payment of some sort. But, that’s basically where the similarities end.
There are two main differences between commercial and residential lending. The first involves the property’s merits and the second involves the down payment. We explain both in the following sections.
What matters most to commercial lenders
Commercial lenders look at three things. I like to think of this as a sandwich. The slice of bread on the top is the property’s net operating income. In the middle, are your financial strengths as the qualified borrower. And the bottom slice of bread is the neighborhood or city that the property is located in.
Looking through the lender’s eyes
Net operating income is pretty simple, we take the income, then subtract the vacancies and expenses. Lenders want to be able to confirm the income by seeing the rent roll, leases, and bank deposits. To document the expenses, you might be tracking down receipts, property tax records, or getting a copy of the landscaping contract.
Your financial strength is based on the assets you own and other income you may have from sources besides the property. Lenders want to see some capital on hand and a steady income so they know you’ll be able to deal with any emergencies or market setbacks.
Lenders will take a close look at the crime statistics, and demographics of the area where your property is located. Our Commercial Dream Team recently had an eight-year-old shopping center under contract in a medium-small town. Even though it was fully leased by national tenants, we couldn’t find a lender who was willing to fund it due to the smaller population in the area.
Therefore, your lender will look at how much money the property brings in, how sound your creditworthiness is, and lastly, whether the property is located in an area where they feel comfortable lending lots of money for years to come. Each of these three parts are very important to a lender when making a decision on your request for a loan.
The down payment requirement is higher
For a commercial property, the down payment requirement is typically 25 dto 30 percent of the purchase price. It is rare for a commercial lender to finance a commercial property with a zero-down payment (as you might see in residential real estate). Because loans made on commercial properties are much larger than on residential properties, commercial lenders have stricter lending guidelines. So, because of the greater risks involved, commercial lenders want the borrower to invest money or equity in the property. This way, they share in some of the risks, or have some “skin in the game” as it is sometimes called.
When purchasing a single-family home, on the other hand, the down payments can fluctuate. It may be 20 percent or more of the purchase price or it may be as low as 0 percent. When the residential lender doesn’t require a down payment, it means that the buyer has no equity in the property.
Evaluating Properties Like a Lender
Commercial lenders are people of a different breed. (Think about it: They live and die making decisions based on Excel spreadsheets.) They look at properties from a different point of view than the rest of us investors. So, it’s wise for you to understand where they’re coming from when they reject your deal. In this section, we help you to understand them, and we show you how to put your best foot forward in getting your deal approved for the best loan.
In order to understand how lenders evaluate properties, you need to examine their three main deal prequalifiers — the property’s income, the quality of the property and it’s neighborhood, and the strength of the borrower.
Determining the property’s income
Income is a vital ingredient to the lender’s approval process. Not only must there be income, but there must also be enough income to satisfy paying the mortgage and property operating expenses. Lenders measure this in two ways, as described in detail in the following sections: debt coverage ratio and loan-to-value ratio.
Debt coverage ratio
A lender’s first checkpoint when determining a property’s income is the debt coverage ratio, which is the ratio of net operating income to debt payments. This ratio basically answers these questions: Does the property bring in enough money to cover its mortgage or its debt? After paying all typical operating expenses, can the monthly income of the property adequately service the monthly debt payment on the property? Here’s how the debt coverage ratio is calculated:
Debt coverage ratio = net operating income divided by annual debt service
Net operating income is the yearly gross income minus operating expenses. However, don’t include any mortgage expenses in this number. Annual debt service is the annual mortgage payments or monthly mortgage payments multiplied by 12. So, for example, if you have a monthly payment of $6,000, the annual debt service is $6,000 @@ts 12, which is $72,000.
Commercial lenders figure the debt coverage ratio because they require a minimum ratio to approve a property for a loan. Many lenders have debt coverage requirements that range from 1.1 to 1.35, but typically the minimum is 1.2. From the lender’s perspective, the higher the debt coverage ratio, the more income that’s available to cover the debt payments, which means less risk for them.
On the other hand, if the debt coverage ratio is less than 1, typically this means that there isn’t enough net income to cover the debt payment. In this case, you have negative cash flow, meaning that someone will be responsible for digging deep in their pockets every month to cover the shortage in cash flow.
Here’s an example showing how to calculate the debt coverage ratio: Say that a property generates a net operating income of $60,000 and the annual debt service is $50,000. If you divide the net operating income by the annual debt service, this gives you a debt coverage ratio of 1.2, which meets most lender criteria.
The loan-to-value ratio, commonly referred to as LTV, is an important factor in the income of a property. A lender figures the loan-to-value ratio by comparing the appraised value of the property to the size of the loan that you’re requesting. This ratio is a percentage:
Loan to value ratio = mortgage amount divided by appraised value of property
Commercial properties are valued for the most part by their net operating incomes. The person who officially values the worth of the property for the lender is called an appraiser. Your goal is to have the appraiser value your property at least for the purchase price. Here’s a quick example of how to figure the loan-to-value ratio:
75% = 600,000 divided by 800,000
So, from this example, if the purchase price equaled the appraised value of $800,000, the down payment or equity in the property would be $200,000, or 25 percent of the purchase price. In other words, the lender will provide a loan for up to 75 percent of the appraised value of the property.
Typical loan-to-value ratios for the lenders are based on the income strength of the property and the financial strength of the buyer. For example, if the property has strong income and the buyers are strong financially, the loan-to-value ratio requirement would be higher, thus requiring a lower down payment from the lender. Similarly, if the property has weak income and the buyers aren’t that strong financially, the loan-to-value ratio would be lower and would require a larger down payment from the lender.
A property that has a strong stream of income can help overcome a weak buyer or buyers. And vice versa; financially strong buyers can help overcome a weak property.
What’s the quality of the property and the neighborhood?
Lenders take risks on properties they don’t manage themselves, so how they deal with this is to lend on properties that are in reasonable physical and financial condition. And having your property located in a stable or growing area can only help them make a positive decision. They also look at the type of tenant in the building. Are they reliable payers, for example? Lenders look at the records from previous years to see how the property has been performing. That’s a good indication of how risky lending money is going to be. This all has to do with the quality of the property, and in this section, we touch on all the quality issues.
A lender looks at the following six specific areas when trying to determine the quality of a property:
* Physical quality of the property: The lender rates the property according to its present physical condition. For example, have you ever walked onto a property that you wanted to purchase and realized immediately that on a scale from 1 to 10, it was a negative 2? You may have told the broker something like, “This property is not worth the amount that the seller’s asking. It’s worth much less because of all the repairs and maintenance that are needed.” Your lender rates property in much the same way.
* Quality of the lease agreements: Lenders determine the quality of the lease by looking at things such as lease renewal options, lease termination, the number of years that are on the lease, whether rent increases are possible, and whether the lease payments include property tax, insurance, and maintenance.
Some would say that when you purchase a commercial property what you’re really purchasing are the leases and the property comes for free. While this isn’t technically true, this helps to point out that if the leases are weak, the property is weak — at least in the lender’s eyes.
* Quality of the tenants: Lenders rate the tenants of a property based on things such as the tenants’ financial strength and how long they have been in business, just to name a few. If you were a lender, would you rather lend on a building whose tenant is Wal-Mart or would you rather lend on the building whose tenant is Ron’s Used Discount Mattresses? As a lender, you have to decide which would be a high risk and which would be a sure bet. If your choice of a sure bet is Wal-Mart, you get a gold star!
* Historical performance of the property: We all have ups and downs in our personal finances, and properties are no different. So, lenders rate the quality of a property by how well it has been operating in the past. Usually a lender favors a property that has at least 12 months of stable operation. As you may have imagined, a rocky financial history can hurt a property’s ability to get a loan. For instance, if an apartment building had income collection problems and now isn’t operating to its potential, because the income is lowered, the value placed on the property would be lowered as well.
* Property occupancy: Do you recall the saying, “Build it and they will come?” Well, in the commercial real estate business, the saying is, “Build it, and then give them a reason to come.” If your property isn’t desirable for any reason, you probably have a history of vacant space. Lenders frown on vacancies.. In fact, typically lenders want to see a property at least 90 percent occupied. Lenders have this type of mindset: “If the property stays full, it must be desirable, and if it’s desirable, the income will be consistent. I’ll make a loan on it.”
* Market occupancy: Market occupancy is just as important as property occupancy. Say, for example, that you want a loan on an apartment building. In the neighborhood in which the property is located, every apartment building is currently 95 percent occupied, but the apartment building you want a loan on is 75 percent occupied. We don’t suggest you try this, but if you do, the lender may require you to put up a higher down payment to make this a less risky deal for them. On the other hand, if the neighborhood occupancy has always been 75 percent, the lender may consider not loaning on the property due to a weak market for tenants to rent the available apartments.
* Rental concessions: This factor has to do with the quality of the market just like market occupancy. Concessions are incentives to the tenants to move in. These incentives rear their heads when the market is soft, and they’re usually in the form of rental discounts. And if the lender sees that concessions are ongoing, they’ll annualize the discounts and subtract them from the gross income, which will affect the loan amount approval. And you thought move-in specials were a good thing!
A lender also looks at the following three attributes of the property’s neighborhood:
* Population: A stable or growing population means that most likely you’ll have a steady pool of applicants to fill any upcoming vacancies.
* Crime: An area with high crime will have a negative impact on the property’s ability to find long-term stable tenants.
* Age: A very old neighborhood could mean the building has old plumbing, an antiquated electrical system, or soon to be crumbling structural foundation.