Questions With a Lender for a Commercial Property Loan
A piece of property is considered to be commercial property when it is five units and above. This includes apartments, office, retail, warehouse, mixed use and flex space. A completely different lender and lending guidelines apply to these properties. It is critical to your success to make sure that you are working with a lender that specializes in commercial loans.
Ask a Lender These Questions:
“What do they have an appetite for?” This means what they are lending on in regards to the categories that are mentioned above.
“What is the commercial loan based on, the loan to value or the debt coverage ratio?” It can be one or the other or it can be both.
“What are the terms that you are offering on commercial loans?” It could be 70% LTV for 25 yrs at 5% and a balloon in 10 yrs. Or it could be a debt coverage ratio of 1.25 for 25 yrs at 5%. These are two different kinds of loans.
For example, let’s say that you have a property that brings in a NOI of $2000 a month and the bank uses a 1.25 DCR. The way that you determine the DCR is that you take the Net Operating Income and divide that by the DCR rate. So, in our example, we have a $2000 NOI and we divide that by 1.25. That gives us $1600 a month for Principle and Interest. If you subtract the monthly payment from the NOI you have $400 a month in cash flow. To determine your annual cash flow, simply multiply by 12. This property has $4800 in cash flow for the year.
“What is the minimum credit score for this commercial piece of real estate?” Usually the bank requires a credit score around 725, but keep in mind that each lender is different.
“What is the debt to income ratio?” Currently lenders are doing approximately 50% maximum debt to income ratio. That means you are allowed to spend 50% of your income towards debt. Debt is principal and interest. Because of Dodd/Frank there is the possibility that the debt to income ratio may be lowered to 43% in the future. Keep in mind that every bank, savings and loan, & credit union has their own loan conditions.
The sixth question you want to ask if you are looking at a loan which is based on debt coverage ratio is “What does the bank require in terms of vacancy rates?”
“What does the bank require in terms of a cash reserve?” Cash reserve can be based on a percentage of the rent. Cash reserve can be based on a dollar amount per unit. Cash reserves are for capital improvements over the investment period that you are analyzing. These numbers take into account cash reserve, utilities, and so forth and reduce the amount of money that you are making and that is called net operating income.
“How much money do you need to set aside for management?” This is a critical number in determining your Net Operating Income.
Net Operating Income is determined when you take the Gross Rents and subtract:
- The vacancy factor
- The taxes and insurance
- The cash reserve
- The utilities
- The maintenance
- The management
- And any additional expenses
Once you have subtracted all of these expenses, you have the Net Operating Income.
Cash on Cash Return
The next thing that you want to evaluate is your cash on cash return. Take the annual cash flow of $4800 from the example above and divide that by the initial investment to determine how much cash on cash return you are making for that piece of commercial real estate.
So what does the initial investment entail? The investment entails your down payment. So let’s look at the payment again $1600 P&I for 25 yrs at 5%. By using a financial calculator you can determine that the loan amount is $298,050. So if the property is selling for $372,563 for example, that would mean you had to put down $74,507 or your investment.
Therefore, a $4800 Cash Flow divided by $74,513 yields a 6.4% cash on cash return. That means at the end of the year you are making 6.4% more than what you invested. In commercial real estate, you are looking for how much cash flow you are getting as part of your financial return.
The financial plan is to get the $74,513 down payment to invest in commercial real estate. There are several ways to get the down payment for a commercial property.
Acquiring a Down Payment
One way is to buy houses below market value, like a short sale or a foreclosure, and then sell them at market value for a profit. You will typically have to do multiple deals to generate a large enough down payment for the commercial property. Once you have enough money, then buy the commercial piece of real estate.
Another way to do it would be to buy a house at a discount, then fix the house up, then sell the house at market value. You may have to do multiple deals to generate enough money for the down payment.
A third way to accumulate that $74,513 is to buy houses in markets that are appreciating, then rent those houses, hold them for a few years until the value increases by that $74,513, then 1031 exchange into a commercial piece of real estate. You don’t have to 1031 the property. You can just sell it, take the money, and move the money into a commercial piece of real estate.
A fourth way would be to bring in investors for the $74,513 and then share the profit or make them an equity partner in that venture giving them a piece of the cash flow and/or appreciation and/or principal reduction and/or tax benefits.
Richard Maryanski and Erik Maryanski
Rich Dad Education Elite Trainers and Mentors