Education, Finance

The Top Ways to
Finance Commercial Real Estate

smartland-the-top-ways-to-finance-commercial-real-estate.mp3 Financing commercial real estate is generally used to acquire, develop and/or reposition a property in line with a sponsor’s business plan... Listen to this article

Introduction

Most commercial real estate, projects both large and small, will utilize some sort of financing. Financing is generally used to acquire, develop and/or reposition a property in line with a sponsor’s business plan.

Given the costly nature of most commercial real estate projects, the amount and type of financing a sponsor uses can have a significant impact on the project’s overall returns. While it may seem insignificant on the surface, a small percentage point swing in interest rates, for example, can result in hundreds of thousands of dollars in interest payments that could otherwise be redirected toward the project (or to investors’ pockets!). Therefore, it is imperative that a sponsor be aware of all potential financing tools and consider which tool is most appropriate given the project’s specifics.

The Most Common Forms of Real Estate Financing

Raising capital for real estate projects is one of the most important jobs of a real estate sponsor. While a lot of attention is paid to raising equity, the sponsor must also analyze how much and what type of debt to utilize as well. Below is an overview of the most common forms of real estate financing, including the pros and cons of each.

Traditional Bank Loans

traditional bank loans

Most real estate sponsors will first pursue financing through a traditional bank, such as Bank of America, Wells Fargo, or JPMorgan Chase. They may also contact more regional or local banks who have specific knowledge of the area real estate market.

One of the benefits to utilizing a traditional bank loan is that they are highly customizable. They also offer attractive pricing and can be used for any form of real estate investment, regardless of product type or business plan strategy. They can be used for the acquisition of property, repositioning of property, or whole-sale redevelopment and ground-up construction efforts. Most lenders will hold the loan (vs. selling on a secondary market), which makes them more amenable to loan modifications as business plans evolve compared to other types of lenders.

Traditional banks tend to be “relationship lenders,” meaning that they want to know the sponsor and the team behind the deal being financed. They will usually want the sponsor to have significant equity in the deal (upwards of 35- to 40 percent) to ensure they have “skin in the game”. Depending on the lender, they may accept less equity in exchange for other forms of recourse. However, in exchange, the lender will usually work with borrowers time and time again as the relationship grows and expands.

Because traditional banks are heavily regulated, most commercial real estate loans will include some sort of performance covenant and/or reporting requirements. At a minimum, this will require some effort on behalf of the sponsor. In more extreme scenarios, a borrower may be forced to right-size the loan mid-term if a performance covenant is not being met.

In short, traditional bank loans are a viable solution for nearly any real estate deal, and they especially shine when flexibility at a competitive interest rate is desired. With that, however, comes an active lending partner that will monitor the deal closely to ensure all loan obligations are being met.

agency loans

Agency Loans (Fannie Mae/Freddie Mac)

agency loans

Fannie Mae and Freddie Mac are two quasi-public governmental agencies whose primary focus is providing liquidity to the U.S. housing market. This makes agency loans an attractive source of capital for those doing multifamily housing deals.

Agency loans can usually only be used on stabilized properties, which limits their broad applicability. However, for those looking to finance a stabilized multifamily project, there is generally no better option than an agency loan as agency loans tend to offer the best terms in the debt markets. Agency loans typically compete with traditional banks, life insurance companies, and CMBS loans and regularly come out on top as the most desirable option depending on the state of the market and the borrower’s priorities.

A few benefits of agency loans are that they are structured as non-recourse and offer long-term fixed rates

A few benefits of agency loans are that they are structured as non-recourse and offer long-term fixed rates. They often feature attractive interest-only periods and may offer borrower incentives for affordable housing and especially environmentally-friendly properties.

These generous loan terms come at the expense of flexibility. Agency loans are securitized and therefore, borrowers do not have the ability to easily modify their loan or prepay without penalty if something changes during the course of their business plan execution. Moreover, agency loan underwriting tends to be rigid. Loans must “fit the box” in order to qualify.

Because agency loans are government-backed and mission-driven, they tend to be the strongest lending option for multifamily borrowers during periods of economic distress, such as the most recent COVID-19 pandemic. Agency lenders remained very active during this time—a time when other lenders sat on the sidelines waiting to see how the pandemic would unfold.

Agency loans are originated through approved lenders that underwrite to agency guidelines. These lenders will usually share a portion of the lender risk and will often continue to hold and service the loan. At a national level, some of the most prominent agency lenders are Walker & Dunlop, Berkadia and CBRE.

In short, agency loans are a strong option for those needing to finance a stabilized multifamily property, but the attractive terms will often come with little flexibility during both the underwriting and amortization periods.

cmbs loans

CMBS Loans

cmbs loans

CMBS loans, which stands for “commercial mortgage-backed security” loans, are loans that have been originated and underwritten by various financial firms, known as “conduits” and then securitized.

Unlike agency loans, CMBS loans can be used for any property type. However, like agency loans, CMBS loans typically provide borrowers with little flexibility if they need to modify the loan for any purpose. This is because CMBS loans are packaged and sold to third-party buyers. The lender who originated the loan does not continue to service the loan over time the way a traditional bank would typically do.

Moreover, because CMBS loans are eventually packaged and sold, there is less focus on the quality of both the borrower and the actual asset being financed. As such, CMBS are often used by borrowers or for deals that traditional banks, life insurance companies or agency lenders would not finance for one reason or another. It is common to see CMBS loans used on properties in secondary and tertiary markets, with an owner who has a less than excellent track record or reputation.

CMBS loan terms fluctuate with the market, but they generally provide long-term fixed rates that are otherwise competitive with banks, life insurance companies, and agency lenders.

Life Insurance Company Loans

Life insurance company loans, often referred to as “lifeco” loans, are similar to traditional bank loans in that the lender typically holds and services the loan and in turn, will look for borrowers to meet specific criteria. As such, lifeco loans are best suited for highly-reputable borrowers looking to finance desirable properties in top-tier locations.

Those who qualify will benefit from flexible loan terms that can be modified as needed to address any issues or changes in business plan execution over the lifetime of the loan. Lifeco loans can also be structured as non-recourse and will often include an attractive interest-only period if so desired.

Where they differ from traditional bank loans is that life insurance companies are primarily looking to lend long-term (10+ years) on stabilized, low-leverage properties (typically, a maximum 60% loan-to-value).

Lifeco loans can be used for any property type, but are most often used for stabilized multifamily, industrial, office, and grocery-anchored retail properties. While less common, they may also be used for “build-to-perm” loans, which are loans used to finance new construction projects that otherwise meet the lender’s criteria. These loans are typically then converted to a more traditional, long-term lifeco loan.

Debt Funds

Debt funds are typically private equity funds looking to make loans on commercial real estate projects. However, in recent years, as hedge funds, private family offices, wealthy individuals and crowdfunding platforms have begun to offer non-traditional financing, the term “debt fund” has started to become synonymous with any private, unconventional lender—regardless of whether the fund is actually backed by fund investors or not.

While debt funds will provide short-term (usually 2-5 years) and non-recourse loans, these loans will come at higher interest rates and with higher fees.

Debt funds are typically private equity funds looking to make loans on commercial real estate projects.

Another key characteristic of debt funds is that the lenders tend to be sophisticated real estate professionals who, unlike traditional lenders, are not afraid to take over the real estate if the borrower defaults on the loan they’ve made. Therefore, debt funds are usually willing to take on more risk, but again, that risk comes at a higher price for the borrowers.

SBA Loans

Loans provided by the U.S. Small Business Administration (SBA) deserve a mention when discussing financing alternatives, but in reality, these loans are only available to borrowers who plan to owner-occupy their real estate.

These loans are most appropriate, for example, for a small business owner who intends to purchase a property and then run their business out of that property.

Real Estate Crowdfunding Portals

In recent years, real estate crowdfunding portals, like CrowdStreet and Fundrise, have become a more popular way for people to secure financing for their real estate deals. These platforms can be used for a variety of purposes.

Some feature their own debt and equity funds. Others allow sponsors to raise capital for their own funds. In other cases, the platforms can be used by sponsors to raise money (debt and/or equity) for individual real estate projects – just as they would raise money for syndications offline.

In recent years, real estate crowdfunding portals, like
CrowdStreet and Fundrise, have become a more popular way for people
to secure financing for their real estate deals.

Real estate sponsors will often leverage crowdfunding portals to raise a portion of the capital they need for a project, which can then be used to supplement the more traditional debt they’ve secured offline.

Hard Money Lenders

Hard money lenders are similar to debt funds except that these are typically individual lenders who operate in small geographic areas and lend on smaller-scale deals. Many house flippers and small-time real estate developers utilize hard money for their projects.

Hard money loans tend to be an option of last resort for borrowers. This is because they carry higher interest rates and more significant points and fees. Most borrowers will only utilize hard money loans in short-term situations, such as during construction or for a quick value-add renovation, and then will pay off the loan and refinance into a more affordable, longer-term loan using a more traditional source of capital.

Seller Financing

Seller financing is uncommon but can be a great financing tool in situations where the buyer and seller have a good relationship. Seller financing is when the seller holds the note on the property, and rather than repaying the bank, the buyer repays the seller just as they would make mortgage payments to a traditional lender.

Seller financing is most often used in situations where the seller is not intending to do a 1031 exchange, and therefore, can save on capital gains taxes by selling the property via an installment sale.

The benefit of seller financing is that it is highly customizable. While there are some general IRS requirements that need to be met, the only other limits to seller financing are creativity and what both parties can mutually agree to.

Conclusion

Whether you’re a real estate sponsor or real estate investor, it is important to be familiar with the breadth of financing tools available for commercial real estate deals. From a sponsor’s perspective, identifying the most appropriate source of capital can easily impact a project’s overall returns. An investor, meanwhile, will want to know that a sponsor has conducted thorough due diligence on the financing available to them for the specific project as this can impact investors’ returns accordingly.

Often, it is not any one source of debt that is used for a project, but rather, a combination of financing tools. As always, a sponsor should be sure to “shop” their deals around to various lenders to be sure they’re getting the best rates and terms available in the marketplace at that time.

Interested in learning more? Contact us today to learn about Smartland’s investment platform.


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