Whether you are a first time investor or a seasoned professional, obtaining a commercial mortgage loan can be difficult for a variety of issues, many of which are typically dependent upon each other. Some of these difficulties derive from things that are out of your control, such as current economic conditions. Other difficulties relate to the lender’s appetite or interest, which is based on the asset, the nature of the transaction, and the sponsor.
In this article, I’ll discuss the current issues impacting lenders and pitfalls to avoid to improve your odds of successfully obtaining commercial real estate financing.
1. Be Organized And Prepared
Being prepared and organized is critical. From the moment you begin working on the project, keep things organized. Not only will this help you be prepared, but help you respond to inquiries promptly. Your level of organization and preparedness is demonstrative of your professionalism. Commercial lenders would much rather deal with organized borrowers versus the alternative. It mitigates their doubt that you will be successful in the project. This is especially important where you do not have prior history with the lender or have a successful track record of projects.
2. Know The Commercial Asset
You need to know the asset backwards and forwards. You should understand the current use of the asset as well as its highest and best use. If the asset is being used as an apartment, but might be better positioned as a hotel, you should evaluate that. If the rents are below market, you need to know why and how you can get them to be in line with the market.
You should be able to identify the asset’s pros and cons. What are the risks? If it has prior use that may impact environmental concerns (e.g., a former gas station), then you should identify those issues and evaluate them up front. If it is being underutilized, you should evaluate why and then be prepared to exploit that opportunity.
You should have visited the property before spending time with a lender. Feel it. Smell it. Listen to it. Ask the neighbors about it. Interview current management and the tenants. Rest assured, your lender will. Never let the lender tell you something about the property that you could have learned yourself.
In sum, while you may not be under contract just yet, you should be able to speak intelligently about the asset when you speak with the lender.
3. Determine Viability
It would make no sense to approach a lender with a transaction if it is impractical. Not only are you going to waste your time and the lender’s time, but you are going to damage your credibility with that lender.
Net Operating Income
First step in determining viability is to calculate Net Operating Income (“NOI”). For purchase transactions, the seller or listing broker may provide you with a NOI. However, never accept it on its face. You should calculate it yourself because they may not be incorporating appropriate assumptions.
Potential Rental Income
– Vacancy & Credit Losses
Effective Rental Income
+ Other Income
Gross Operating Income
+ Operating Expenses
Net Operating Income
The NOI is the amount of cash available to service the debt. It is also the figure used to calculate the cap rate and other rate of return figures, as well as the critical DSCR ratio.
Debt Service Coverage Ratio (“DSCR”)
The DSCR is the ratio of cash available for debt servicing. To calculate this, find the sum of your monthly debt obligations and divide it by NOI.
Debt Service Coverage Ratio = NOI / Annual Loan Payments
Determining the annual loan payments will be dependent upon accurate assumptions for the debt amount and making sure you are within the reasonable boundaries for leverage amounts.
Understanding Leverage Boundaries
Understanding where the boundaries are will help you determine viability. For example, do not approach a lender seeking 95% LTV.
The LTV is dependent upon several risk factors, such as lender type, asset type and quality, and amortization. For example, on top tier multifamily, you can obtain 80% LTV and a 30-year amortization. For high grade CRE, you may be able to obtain 80% LTV from an institutional lender, though probably with a maximum 25-year amortization. As a rule of thumb, underwrite your deals with a maximum of 75% LTV and a 25-year amortization, and see where they shake out. Even minor tweaks in assumptions such as vacancy or reserves can kill a deal that otherwise only worked at a 80% LTV and 30-year amortization.
For deals where you know the commercial lender will be a private lender, you may be able to get a higher amortization (e.g., 30-years), but a lesser LTV (e.g., 65-70%).
For rates, as they are dynamic and constantly changing, it is difficult to create a universal formula. Currently, there is about a 3% gap between institutional permanent financing, private permanent programs, and hard money programs, as the average rate for these programs is about 5%, 8%, and 11%, respectively. These are assumptions based on current market conditions.
4. Evaluate the Nature Of The Transaction
Things like non-recourse, cash out, and out-of-state sponsors often have a direct impact on your ability to get financing. For bank lenders, these are typically deal killers. For non-bank institutional lenders, some of these issues can be problematic. Having an advisor help guide you through these issues is important to maximize efficiency and success. For example, understanding what is most important helps prioritize and eliminate lenders that don’t or won’t fit the transaction.
If you’re doing a reposition transaction, have a business plan. Identify how you will execute on your plan, what it will cost, who will do the action, and when it will be accomplished. If you need to incorporate an interest-only period, be prepared to explain why, even if it seems obvious. The theme is organization and accountability.
5. Get Your Documents And Team In Order
In CRE lending, the property’s financial performance — i.e., the income it generates — is the most critical. Therefore, before you approach any lender, you need to gather as much information on the property’s financials as you can and prepare the necessary pro formas to tell the story.
For stabilized properties, you want 3-years of historical financials, a current rent roll, and last 3-years of tax returns. In a purchase transaction, the seller may not be willing to provide you 3-years’ of financials and prior tax returns, but you should be able to get at least the trailing 12-months and a current rent roll. If the seller of a stabilized property is unwilling to provide that information, you should probably walk away from that transaction. In a refinance transaction, there is no excuse for not providing and having organized last 3-years of financials.
If the transaction is a reposition or value add, then you should have a 3-5 year pro forma showing a before and after financial outlook. Assumptions for vacancy, reserves, and build out should err on the side of conservative.
Leases And Contracts
If you can obtain copies of the leases and any other management related contract, you should do so. You should have these organized and readily available for the lender. You should review the leases to determine rights, expiration dates, renewal options, etc. You should reconcile against the rent roll. For management contracts, you should review to understanding expiration dates, renewal options, and reasonableness of price versus the scope of duties and obligations.
In addition to the property financials, the sponsor should also have his or her financials in an organized package. As a starter, you should have your last three years of personal tax returns available to provide to a lender. You should have them in digital format and stored in a safe, cloud-based vault where you can quickly share with lenders. Tax returns are virtually guaranteed to be required for banks and credit unions, though unlikely to be necessary for private lenders.
You should also have a current Personal Financial Statement showing your assets, liabilities and net worth.
Lastly, you should understand your credit score. You can obtain your credit score for free using any of the online credit score sites, such creditkarma.com. If your credit score is below 700, you should look into what is impacting your score. You should clear up any inaccuracies or blemishes on the report. Existing delinquencies and prior charge offs will impact you negatively so be prepared to provide a written statement explaining these issues if they do exist.
Have Your Team Ready To Go
You should have a team consisting of one or more persons that can help you with legal, title, corporate formation, accounting, and management. You need to be able to move fast so having these folks teed up is vital. Members of your team should be experienced so as to mitigate delays and errors.