Commercial real estate loans are very different from residential loans. They are much more complicated and carry terms and conditions different from residential loans. These are reasons that many investors never venture in the commercial real estate market. Smaller residential real estate investors are typically limited to somewhere between four and ten properties valued in the hundreds of thousands of dollars before lenders conclude their risk level is sufficient that no further loans will be made. This can be highly limiting to the residential investor.
Commercial loan requirements can vary significantly between bank and private lenders. Also, loans held in the portfolio of a single lender may vary widely, depending on the risk the lender perceives accompanies individual loans.
Generally, banks require you and/or your investment partners to come up with 20 to 25 percent of the property value as a down payment. On a $600,000 purchase, the borrower needs to contribute $120,000-$150,000 towards the down payment. Additionally, research has consistently shown that the number one reason commercial loans default and businesses fail is because of the lack of adequate capital to meet cash-flow needs. For that reason, banks often require the business maintain a significant cash reserve that can be drawn on if cash flow is not adequate to make the loan payments. This financial requirement is in addition to the hefty down payment. One strategy that some commercial investors use is borrowing as much money as they can (even at a higher interest rate) to provide ample capital to build out the business and there by increase cash flow.
Another notable difference between commercial and residential loans is that banks don't want to carry the loan for a full 20 or 30 years. Banks generally require a balloon payment 3, 5, or 10 years after origination of the loan. The original loan can be amortized over 20 or 30 years but the balance of the loan must be paid in full when the balloon payment comes due. Seldom does the borrower have the funds to repay the entire loan.
This leaves him or her with the need to either refinance the loan or find another financing source. This can present several problems. Least of which is the requirement to again pay all of the loan origination and associated fees to take out a new loan. Bigger problems arise when the industry or individual business is in financial distress when the balloon payment becomes due, preventing the business from qualifying for a new loan. If the loan payments are current and being made on time, the lender will often continue to carry the original loan. But this won't go on indefinitely because the original loan is now in default of the loan terms.
Private lenders and other non-bank lenders typically offer less rigorous commercial loan requirements. Some non-bank lenders require a lower down payment in the 10 to 15 percent range. Additionally, these lenders are often agreeable to carrying the loan the full 20 or 30 years until it is paid off in full (no balloon payment). However, these lenders charge a slightly higher interest rate. Typically one or two percent above the bank rates.
Do the math. That higher interest rate might not be as expensive as it first appears. First, calculate the full cost of the higher interest over the entire length of the loan. Compare this to the cost of paying to open a new loan two or three times as the balloon payments come due. Next, consider the financial security you gain when you don't need to worry about qualifying for a new loan at a point in time when the economy or your business is under performing.
Commercial loans with balloon payments really can be a big issue. Commercial bank loans for smaller investors were almost impossible to obtain during the depression. Today, some of the earliest post-depression loan balloon payments are coming due. Morningstar tracks the performance of these balloon payments and has this to say about March performance:
"The payoff rate for maturing loans in commercial mortgage-backed securities hit its highest level in more than a year; however Morningstar Credit Ratings, LLC still believes the rate will deteriorate later this year. Of the loans maturing during the March remittance period, some $4.17 billion, or 88.8%, paid off, the highest rate in 14 months.
The volume of CMBS loans due for repayment fell for the second consecutive month in March to $4.70 billion, the lowest monthly total since April 2015. In March, 368 of the 439 performing CMBS loans were paid in full at maturity, or approximately $4.17 billion. Multifamily collateral continues to perform well, with a payoff rate above 90% for the seventh-consecutive month. The three-month postmaturity payoff rate was 90% in March, marking eight out of the previous nine months it was 90% or above."
The emergence of nonbanking commercial lenders are challenging banks on their traditional loan terms. While banks continue tightening loan requirements, non-bank lenders are going after a larger share of the market by making it easier to qualify. If you are looking for a small commercial loan (less than $2 million) up to a medium loan (less than $5 million), take the time to seek out lenders offering you acceptable terms and time constraints.
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Author bio: Brian Kline has been investing in real estate for more than 35 years and writing about real estate investing for seven years. He also draws upon 30 plus years of business experience including 12 years as a manager at Boeing Aircraft Company. Brian currently lives at Lake Cushman, Washington. A vacation destination, a few short miles from a national forest. In the Olympic Mountains with the Pacific Ocean a couple of miles in the opposite direction.