Andie Wilson and Brad Bonkowski: The challenges of commercial lending
Many people own residential investment property like single family homes or duplexes, but the number of people who own commercial investment properties (office, retail, industrial properties) is much lower. Why is that?
One reason is simply that most small investors are more comfortable with residential properties. It can be more difficult to manage the intricacies of commercial properties. But one of the greatest barriers to owning commercial properties is actually obtaining a commercial loan — not only qualifying for one, but fitting your investment goals into the constraints of one.
When qualifying for a residential loan, there are some basic parameters for qualification, such as having a certain history of employment, and the monthly mortgage payment can’t exceed a percentage of the borrower’s income. When obtaining a commercial loan, the bank also considers these characteristics, as well as the amount of other income sources or other investments that the borrower has, the cash flow that the investment property creates every month through received rents and the remaining terms of the leases, as well as the condition and occupancy of the property itself.
However, the terms of a commercial loan are typically very different. While a primary residence may be purchased through different programs with as little as 3 percent, 5 percent, or 10 percent down, most commercial loans will require a minimum down payment of 20 percent, and most likely 25-30 percent. Land can require 50 percent down payment.
Additionally, most residential mortgages are fully amortized over 30 years, meaning that the borrower makes consistent monthly payments over a 30-year period, until the final payment is made at the end of the 30-year term, and the mortgage is paid off. A typical commercial loan may be amortized over 20 or 25 years, meaning the monthly payment is calculated as if the loan would be paid off over this 20- to 25-year period of time, but there is a balloon payment at the end of 5, 7 or 10 years, so the loan must be completely paid off at that time, as a lump sum. This can obviously be a huge concern, so when a borrower is purchasing a commercial property and obtaining a loan, they usually have a very clear goal or path intended for ownership… Either they will sell it prior to the balloon payment due date or they will carefully plan to refinance prior to that payment coming due.
The costs of a commercial loan are much higher than a residential loan. Interest rates for conventional commercial loans typically run 1 to 3 percent higher than residential loans. Additionally, there may be “points” to be paid, which amounts to prepaid interest payments to get the loan.
While a residential appraisal may cost about $500, a commercial appraisal typically costs about 10 times that amount. Between the appraisal, the loan points, expensive required inspection costs, like a Phase One environmental inspection and a structural inspection, the costs of obtaining a commercial loan can easily run many thousands to tens of thousands of dollars, depending on the value and complexity of the property.
Another little known fact about commercial loans is that the bank can, and usually does, require the borrower to submit a complete, updated financial statement once a year. This allows the bank to verify that the property is creating the anticipated cash flow, and also that the borrower is financially solid. If a borrower has fallen on hard times, the bank wants to know that before their interest in the property becomes jeopardized. If a borrower loses their job, or the property has vacancies that stop the property from properly cash-flowing, the bank may decree that the borrower is in default of the loan covenants, and actually call for the loan to be (*surprise!*) paid off or the principal amount of the loan reduced!
In summary, commercial loans are completely different than residential loans, which is why, when we are working with a buyer who needs a commercial loan, we typically recommend that the buyer work with a commercial loan specialist who has an in-depth knowledge of these very complicated loan products. This is also why commercial properties which offer owner financing are always in demand.
Brad Bonkowski, CCIM and Andie Wilson, CCIM are owner/brokers of NAI Alliance Carson City, a commercial real estate brokerage. They can be reached at (775) 721-2980.