THE DIFFERENT WAYS OF FINANCING COMMERCIAL REAL ESTATE
Financing a commercial real estate deal is one of the most critical elements of getting a deal across the finish line—no money equals no investment. With these deals, which are usually much larger or more expensive than a typical residential property sale, most investors need to use debt to purchase, build or renovate the property.
Investors have a variety of commercial real estate financing tools at their disposal. However, investors must carefully weigh the options available to them, depending on the property type, location, and purpose of the loan.
For example, not all loan products are available for every product type, and not all lenders offer the same loan products. It’s a case-by-case basis, which is why commercial loans can seem complicated to those unfamiliar with the space.
Here, we look at the many ways to finance commercial real estate—from traditional loans to innovative crowdfunding platforms and many options in between.
What is Commercial Real Estate Financing?
Most commercial real estate, like most residential real estate, is purchased with a loan. Not many people buy a property outright. The process of obtaining a loan for the purchase of an investment property is known as commercial real estate financing.
Commercial real estate financing has many more components to consider than financing a single-family home or other owner-occupied residential assets. Unlike home loans, commercial property loans are usually particular to the borrower and the individual deal.
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Paths to Financing Commercial Real Estate
Most borrowers default to calling their existing lender or bank when buying commercial real estate, which is a good beginning step. But, borrowers also need to make sure they know all of the financing options they can adopt for a deal to best suit their situations.
By only looking at one lender’s options, you may unknowingly be ruling out other potentially better financing options. Depending on the nature of a deal, the alternative financing options may be better tailored to their needs. Borrowers should explore the full range of options before committing to one, especially due to the size and scale of most commercial real estate deals.
Conventional financing, also known as the traditional bank loan, is the most commonly used tool for financing commercial real estate properties. A traditional bank loan can usually be highly customized compared to other sources of commercial real estate debt, providing the most flexibility to borrowers.
Both small local banks and large national banks offer conventional financing. In contrast, smaller banks typically have hyper-local decisions to consider, meaning they can be more flexible based on their understanding of the specifics of the local market.
Banks operate very differently depending on their geographic location and market space, how well capitalized they are and how aggressive they become during negotiations.
All banks are limited to how much they can lend to individual borrowers and as a proportion of their overall loan portfolio, which can be restrictive, especially for smaller local banks. Larger banks have the same kinds of regulated lending restrictions but can cater more readily to larger borrowers because of their size.
When financing large commercial real estate transactions of $10 million or more, most borrowers want to contact a national lender like JP Morgan Chase, Bank of America, or Wells Fargo.
National lenders commonly go in for a piece of the debt (say 40% of the loan) then have the local bank put up another piece (say 30% of the loan), with the borrower putting up the remaining balance as equity.
Agency lenders, also known as government-sponsored entities, are not actual lenders. Federal companies have created loan programs specifically tailored to finance multifamily real estate properties to ensure the US population has abundant and affordable rental housing. But, these loans can only be used to finance multifamily transactions. Companies like these include Capital One, Fannie Mae, and Arbor Commercial Mortgage.
Agency loans work like this: an agency lender has specific standards that you must meet to be guaranteed a loan for your multifamily investment property; let’s assume you’ve been approved.
A traditional bank then makes the loan but holds what is known as an “implied guarantee” in which, if the underlying collateral goes bad or if the borrower defaults on their loan, the lender will step in to pay the debt on the bonds. (These loans are very attractive to investors because they create a safety net for lenders.) The loan is then divided and sold as bonds to investors.
Commercial mortgage-backed security (CMBS) loans are structured through an entity—usually a large bank—that makes commercial loans then packages and sells them off to the public as bonds.
CMBS loans are available for all real estate property types, not just multifamily (as with agency loans). Unlike traditional bank loans, CMBS loans are usually long-term loans on properties with a stable cash flow, best suited for those who don’t need an active lender.
However, CMBS loans offer little flexibility for lenders. For instance, many commercial real estate owners experienced a disruption in their cash flow due to COVID-19 and had difficulty covering their debt services.
In these scenarios, a borrower’s best option is to renegotiate their loan with the lender, but CMBS loans are often difficult to restructure. Borrowers are not given the same access to the decision-makers who could modify their loans or offer some other form of debt relief.
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The United States Small Business Administration (SBA) has several loan programs that investors can use to finance commercial real estate. SBA loan programs are best for small businesses that intend to owner-occupy the real estate being financed. The most prominent SBA loan programs in the CRE industry include:
SBA 504 Loans
SBA 504 loans are loans for up to $5 million—usually $1 million or more—to help small businesses trying to expand or improve their operations. To get a 504 loan, the business owner needs to contact a “Certified Development Company,” a partner with the SBA that can provide these loans.
These loans are used to buy real estate properties, finance the construction of a new building, refinance the debt or buy equipment needed for the business. The SBA 504 loan program requires borrowers to pay 15–20% upfront, which is lower than a conventional lender that needs at least 30% down.
SBA 7A Loans
The SBA 7A loan program is one of the most popular financing tools for owner-occupied commercial real estate. This program gives up to $5 million in funds for small businesses, with up to $3.75 million guaranteed by the SBA, providing a boost for borrowers who need to improve their creditworthiness.
To be eligible, the real estate owner must be the operator of the business and the business must be structured as a for-profit entity. SBA 7A loans are provided by traditional bank lenders, including Wells Fargo and JPMorgan Chase (unlike SBA 504 loans that require you to obtain financing with a CDC).
HUD Section 232 Loans
Although not a typical SBA loan product, HUD Section 232 loans are offered by the federal government. These FHA/HUD loans typically start at $2 million and are used to finance senior housing communities, such as senior living, assisted living, and other related senior-care facilities. The loan program also has no maximum amount for facilities with at least 20 residents.
Borrowers typically seek out seller-carried financing when they struggle to obtain bank or other traditional financing. In these cases, the seller agrees to carry the note and provide the buyer’s debt to acquire the real estate property. The buyer will then repay the seller (principal and interest) like they would pay the bank in a traditional loan scenario.
The benefit to seller-carried financing is the borrowers have more freedom to negotiate terms. For example, you may be able to negotiate a lower interest rate or an interest-only period, or you could negotiate full, partial, or non-recourse terms for the deal.
Seller-carried financing can also attract sellers who are having difficulty finding a buyer for their property, which may appeal to the property owner depending on the terms the seller is willing to offer.
The seller can receive unique tax benefits, too, since they are not selling the property outright like a traditional real estate sale—they could be able to defer payment of capital gains tax for some time.
Hard Money Loans
Hard money lenders are third-party financiers that usually offer loans at rates above the market valuation. For instance, a hard money lender may charge 12% interest on financing a property that a traditional lender might charge just 5.5%.
Though the numbers don’t seem to make sense for a borrower to choose a hard money lender over a more traditional lender, several circumstances can account for why it may be necessary.
Hard money lenders can typically move capital much faster than traditional lenders. For example, if a borrower needs to make an immediate down payment or wants to make an all-cash offer on a property, a hard money lender can provide that cash quickly.
The borrower can now provide the cash in the short-term while figuring out a longer-term, less expensive financing solution.
Borrowers might also get a hard money loan depending on the risk of the venture or person. High-risk deals (and/or high-risk borrowers) may have difficulty obtaining traditional commercial financing loans; they could have no other option than to enter into a hard money loan.
Once the project stabilizes, the borrower can refinance the property to repay the hard money lender and put lower cost, long-term debt on the deal.
In essence, hard money loans are generally used only as a last resort.
Online crowdfunding platforms are fairly new to the commercial real estate financing industry but have already piqued much investor interest.
Real estate crowdfunding platforms, like CrowdStreet, provide an alternative source of real estate debt and equity for those in need of financing. These platforms came about due to changes to the 2012 JOBS Act, which modified the SEC regulations to now allow people to invest in real estate like they would with other more traditional securities.
The change first only allowed accredited investors to invest in real estate debt and equity through these online platforms but now allow non-accredited investors to invest.
While most real estate developers use these platforms to collect equity investments, these digital marketplaces also accumulate capital for debt funds—then those debt funds invest in different commercial real estate deals.
Crowdfunding platforms have allowed professionals to finance their commercial real estate projects by finding willing sponsors to fund their equities and debts.
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Final Thoughts on Ways of Financing Commercial Real Estate
As you can see, there are many ways to finance commercial real estate. Ultimately, the financing tools available to any borrower will depend on the deal’s structure, including but not limited to the type of borrower.
One of the primary factors influencing a borrower’s financing options is their creditworthiness—much different from the simple credit check a lender runs for a single-family home loan.
With commercial real estate deals, the lender evaluates the borrower’s credit risk factors, including:
- Track record with repayment
- Reputation in the marketplace
- Relationship with the bank to date (if any)
- The borrower’s overall financial capital (both for the company and personally)
The lender will decide the borrower’s ability to access additional capital (debt or equity) because if something with the deal goes wrong, the lender wants to know repayment is possible.
This is another reason why commercial real estate financing tends to be specifically tailored to individual deals. The lender really wants to investigate the specific factors of a deal, both the real estate property and parties providing capital for the deal, to understand the various risks before offering a loan.
Borrowers should be aware of all their real estate financing options to ensure they are getting the best deal. When in doubt, contact a commercial real estate debt broker to advise you on your options.
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