Five Major Types of Commercial Real Estate Finance Sources: What You Should Know
The commercial real estate landscape is constantly shifting, responding to changes in everything from transaction density to underwriting trends. For everyone investing in real estate, it’s important to stay up to date with these changes and understand what funding sources are available in the current market.
At present, commercial real estate capital solutions fall into one of five broad categories.
#1: Equity Investors
An equity investor funds a percentage of a commercial real estate transaction. In exchange, that investor receives a percentage a share of the property’s ownership.
This relationship is very different than what you’d experience with a lender. Instead of a borrowed sum that you pay back and walk away from, you essentially enter into a business partnership that will affect your revenue and operations for years to come.
What you’re getting
Unlike debt instruments, equity investments do not require you to repay them dollar for dollar. Their returns tie directly to your revenue, which can be helpful if your revenue is uncertain.
As the property owner or sponsor in an equity investment situation, you contribute a percentage of the transaction’s purchase price. Investors need to know that you have a stake in the game. You also assume responsibility for all losses that the property might incur.
If the property turns a profit, you will split the profit with the investor. Your equity agreement specifies the percentage of revenue that the investor will receive. This is how the equity investor recoups his or her investment.
Because an equity investor becomes part owner in the property, you will be paying that percentage throughout the project’s lifetime. You may also need approval from your investor for all major project decisions.
If you plan to hold the investment for a long period of time, think about whether you’d be giving up too much by entering into an equity arrangement. You may choose to consider other options.
#2: Opportunistic Lenders
Opportunistic lenders fund properties that pose a higher investment risk. They work with investors who don’t have a reasonable guarantee of revenue or need to put a lot of money into a property before it becomes tenant-ready.
What you’re getting
Investors usually turn to opportunistic lenders when they see CRE investment possibilities that other lenders would turn down. That includes properties which:
need a significant or complete renovation
are completely vacant at the time of purchase
require ground-up construction.
An opportunistic lender approves a loan application when the lender sees the same potential that you do. They understand that these projects can generate great returns, so they’re willing to fund a large portion of the project.
Mezzanine lending is a well-known form of opportunistic lending. It fills the funding gap between what you receive from a senior lender and what you contribute on your own. Mezzanine loans let you act quickly on properties that you can’t fully fund otherwise, but they charge accordingly.
Mezzanine and other opportunistic lenders tend to follow the old adage of “beggars can’t be choosers.” Because they accept high-risk borrowers, they balance out that risk by charging higher interest rates, higher down payments, and other less favorable terms. If you’re not confident that your portfolio can handle it, rushing into an opportunistic lending arrangement can get you into trouble.
#3: Conduit Lenders
A conduit lender provides a commercial mortgage backed security loan, or a CMBS. The lender will package your loan along with several others and place them into a conduit trust for investors. You’ll work with the lender to originate the loan, but a master servicer will process it.
Conduit loans fund a broad range of CRE properties, from multifamily residences to industrial and warehouse buildings. Smaller banks don’t offer this kind of funding, so you’ll most likely have to go to a big bank like Chase/JP Morgan, Wells Fargo, or Citibank.
What you’re getting
With a CMBS loan from a conduit lender, you get a fixed-interest rate loan with a term of five to 10 years and amortizations of 25 to 30 years. To qualify, a conduit lender will look at your:
loan-to-value ratio (LTV)
debt service coverage ratio (DSCR), which is your net operating income divided by the debt owed on the property, and
debt yield, your net operating income divided by the loan amount, times 100.
You will also need to prove your status as a bankruptcy-remote, single-purpose entity.
CMBS loans from conduit lenders usually offer more flexible terms and lower interest rates than other CRE funding options. They are fully assumable and nonrecourse debts so not only can you transfer them to your buyer if you sell the property, but the lender can’t go after your personal assets if you default.
liquid assets worth at least 5 percent of the loan total
equity of 30 percent to 40 percent
a DSCR of 1.25x to 1.35x
LTV of no more than 75 percent.
You will also be responsible for any prepayment penalties if you pay the loan off early. This is common practice in conduit lending.
Banks tend to be the lender of choice for smaller-scale CRE investors seeking owner-occupied property. You can also get funding for multifamily and non-owner occupied property investments from a bank, but banks are more likely to process this kind of funding as investment property loans.
Wells Fargo, primarily for experienced developers and large projects
JP Morgan Chase, primarily for multifamily projects up to $25 million
US Bank, primarily for owner-occupied CRE loans Additional options include:
PNC Real Estate
Bank of America Merrill Lynch
This list is not exhaustive. To find the best fit for you, consult a CRE investing professional.
What you’re getting
If you’re in the market for long-term lending, you can get SBA-backed commercial real estate loans valued up to $5 million from national banks. These loans usually have 10- to 25- year terms. Shorter-term loans tend to take the form of bridge loans or hard money loans.
Investment property loans tend to fund projects up to $2 million and are best for prime borrowers. There are larger loans available, but these usually come from money center banks.
CRE and investment property loans may have fixed or variable interest rates, depending on the lender. The length of the application process also varies by lender, so research each of your options in detail.
A commercial real estate loan from a bank requires your business to occupy 51 percent or more of the property and will ask for a down payment of 25 percent to 35 percent of the property’s value. In most cases, you’ll also need a DSCR of no more than 1.25 and an SBSS score of 140.
have an LTV ratio of no more than 75 percent to 85 percent, depending on lender type, and
pay an interest rate of 4.5 percent to 6.5 percent if you borrow as an individual or 6.5 percent to 12 percent if you borrow as a business.
Every loan will have different terms, and there are dozens of possible combinations of terms. A description of all available products is beyond the scope of this article, so make time to discuss all available options with your bank.
#5: Life Insurance Companies
Life insurance companies can be great sources of CRE lending for investors in stable or growing markets. Insurers tend not to be particularly risk-tolerant and prioritize well-qualified borrowers with prime properties.
What you’re getting
Loans from life insurers are usually five-year to 30-year terms with amortizations of 15 to 30 years. Some companies are also beginning to offer mezzanine loans or short-term bridge lending, allowing you to source short-term as well as long-term funding from an insurer. In all cases, terms are generally favorable but limited to those with strong credit profiles.
Like bank loans, CRE loans from the life insurance market vary significantly in their borrowing terms. Depending on the insurers you apply with, you may find loans that are:
recourse, limited recourse, and non-recourse
assumable or non-assumable
self-amortizing or ballooning at maturity
restricted with different forms of prepayment penalties or not restricted at all
Traditionally, CRE borrowers have associated life insurance companies with stricter underwriting terms, but increased competition from other sources has made many insurers more flexible.
You now have a better understanding in what to expect from different types of CRE lenders. Do be aware that there are many more details involved and many options within each category. Consider getting help from a skilled and knowledgeable professional in commercial real estate finance and capital markets before you commit to a real estate funding source.
We hope you find this Newsletter insightful and meaningful. Our team is available to assist you with your real estate financing and capital solutions. We look forward to the opportunity to serve you in the near future. You can reach us or call us here!
By Dianne Black|2021-06-15T16:53:35+00:00May 17, 2019|Insights|Comments Off on Five Major Types of Commercial Real Estate Finance Sources: What You Should Know