You build the building, lease it out to tenants – and everybody’s happy….the logic of Commercial Real Estate isn’t that difficult.
Until you get to the financing stage, that is.
I don’t think they do it on purpose, but once you get so entangled in industry jargon – it’s hard for lenders to realize how complex the process is to new Real Estate Investors and/or Developers.
That’s one of the many reasons I started The Red Door Capital Group, and that’s one of the many reasons I wanted to provide some clarity on this subject….
What is Commercial Real Estate Lending?
It’s pretty straightforward. Commercial Real Estate lending refers to the financing of Commercial Real Estate.
And Commercial Real Estate includes any type of building that’s used for Business purposes. Including:
- Office Buildings
- Shopping Centers
- Rental Houses
How It Works
Okay, now we need to think about the next step – will you be building a new property, or purchasing an existing property?
And there’s not a “right” answer, I only ask because of the next step – as it will make a difference.
If you’re going to purchase an existing property, that streamlines a lot of the process. You simply make sure the value is worth the purchase price (verified by appraisal), and make sure the projected income can cover your projected debt payments.
Projected income in this situation generally refers to rental income, from a personal (apartment) or business (office building) tenant.
And that’s really about it. Of course there’s a little more detail as the process gets going, but you don’t have to worry about that much now.
Then there’s the other method, developing your own building. There’s a lot of perks to this method, but I think it’s just nice to create your own layout and know you have a new building.
The process overall is very similar to buying an existing building, except for the first part – where financing takes place on a building that’s not even there…
That’s where things get tricky.
Nobody wants to give you all the money upfront, so a process was made to protect both parties.
And the first step of that process is what many refer to as a “bridge loan” – the loan that bridges the gap between idea and long-term financing.
This type of loan is really a hybrid between a line of credit and a traditional term loan. You’re given a maximum credit line (so you know you’ll be able to get all the needed funds), but there’s milestones in place that restrict how much money you can have.
These milestones will be different for every situation, but I always look at is as a “to-do list”, where funds are released after one “to-do” is completed.
An example of this would be to have only $20,000 available until the foundation is complete. The lender understands that this is important before anything else can happen, so they’ll restrict the funds until they know the foundation is ready.
And after the foundation is ready, they’ll come out for an “inspection” – and if everything looks good, they’ll approve this and move on to the next milestone.
The next milestone could be a few different things, but it’s something you’ve already agreed upon – and the credit limit is adjusted to cover the needed expenses for that particular milestone.
This process keeps going until the building is complete, and with most lenders – you’re only liable for the interest that accrued throughout each month. They understand you’re not receiving income for this project yet, so they won’t make you start making full payments at this time.
That takes place when the project is completed and the bridge loan has “matured”. A.k.a – you’re no longer in the building process, they want you to refinance into a fixed loan that requires set monthly payments.
Similar to what you’d see if you purchased an existing building.
Special Note: Another thing to consider is capital improvements. That’s common with building purchases, so there’s either wiggle room baked into the final loan or another option is there to cover these expenses – like a line of credit.
Other Areas to Consider
That’s pretty much the entire lending process. Things get a little more complex once the mountain of paperwork starts to print – but the logic remains the same.
With that said, there are a few things you should always consider when the paperwork starts to print – because the fine detail could make a big difference down the road.
We’ll start with the easy one first, interest rates. Of course you want to get the lowest rate possible, but you also have to watch out for rising interest rates.
Real estate is expensive, and the loans aren’t small – so you generally need a longer term loan.
And longer term loans can cause some risk to banks, so they try and mitigate this with “review periods”.
Like a maturing bridge loan, review periods take place when both parties have to look at the loan.
A good example of this is when you have a 5 year term, but the loan is amortized over 15 years (meaning your payments are structured over a 15-year term, although the loan “balloons” in five).
The lender has every intention of renewing this loan after 5 years, but they have these review periods in place to make sure everything is okay. In other words, they don’t want to give you a 3% loan and have interest rates at 8% in 5 years – that’d mean they’re losing money.
Another thing to look out for, and this is especially true if you’ve never dealt with Commercial Lending, is Loan Covenants.
What are covenants? A fancy word for additional loan requirements.
You can get into detail and start discussing normal covenants or negative covenants – but they both mean additional loan requirements.
Another way to look at these are “conditional rules”. If a certain measurement goes outside the covenant calculation, they can call the note due. Technically this means you’re supposed to pay the note in full right away, but they weren’t born yesterday – so they’ll generally just ask you to refinance elsewhere.
Typical covenants range from debt service coverage to making sure real estate taxes are paid.
The lender wants to make sure you have enough income to cover payments, and they’ll require a little buffer to make them more comfortable.
Same with real estate tax, but they probably won’t have a buffer in this situation. They just want to make sure the taxes are paid so no other debtors can start making claims on the property – little wiggle room for negotiation.
The last item I wanted to talk about was personal finances. This isn’t something that many people think about with business lending, but if you’re the owner – you’re the business.
Sure they’ll take other considerations into place, but if you have a 500 credit score and a history of missed payments – why would they believe you’ll make payments on the business loan?
On top of this, they’ll generally have you as a guarantor on the loan – so they might have some covenants on your personal finance as well.
Like telling you you can’t sell any investments without their approval, because they want to make sure you have some liquidity in case the building income drops and can’t make the full payments.
Commercial Real Estate Lending – Recap
Things can get complicated, but they don’t have to. You’re developing (or buying) a building that’ll be leased out to tenants – and that’s it.
Don’t let additional requirements and tedious details slow you down, that’s what we’re here for – to help you out.
If you’re interested in starting a real estate portfolio, or maybe refinancing an existing debt – then please don’t hesitate to reach out, there’s a good chance we’ll be able to help.
Questions or comments? Please let us know below!