Author: Chris C July 23, 2019 0 Comments

As we continue to move further into what has become the nation’s longest economic expansion, and one that has been GREAT for real estate investors, I am encountering more and more residential investors who are interested in opportunities within the commercial real estate realm. When I talk about commercial real estate here, I am generally talking about business-purpose real estate which includes things like industrial/warehouse space, flex space, office buildings (including medical office), retail (single-tenant or multi-tenant), and multifamily (any apartment with 5 or more units).

Remember that when we talk about single-family residential, this includes duplex (2-unit), triplex (3-unit), and quadplex (4-unit) residential properties…collectively we refer to these as single-family residential 1-4 or SFR 1-4. One of the main reasons we make this distinction is because of how these properties are financed. Typically SFR 1-4 properties can be financed with conventional residential mortgages…including the popular 15 or 30 year fixed rate loans offered via Fannie Mae, Freddy Mac, FHA programs, etc. But there are a couple important limitations with these loans – First off, you are typically limited to financing no more than 10 properties with this type of loan. Second, you need to borrow these loans (and property is supposed to be titled to) a personal name, not a business entity such as an LLC or partnership. In many cases for liability reasons as well as diverse ownership structure (owning a property collectively with multiple partners), your accountant or attorney will recommend taking ownership of the property under an LLC. All of these are situations which would prompt you to consider a CRE loan.

 

When I work with first-time CRE borrowers who have experience in borrowing for residential loans, there is always some initial sticker shock at some of the costs involved. I like to spend some time up front with my first-time CRE borrower clients to make sure they understand this so there are no surprises. Some of the most common cost differences a borrower will encounter with a CRE loan include:

• Appraisal: Commerial real estate appraisals are a much more detailed report than your typical residential appraisal. In addition to providing a value based on sales comparison approach and market approach, a CRE appraisal will include a valuation conclusion based on the income approach. This detailed report comes at a cost. While the range can vary based on local market and complexity of the appraisal (construction vs existing building, single-tenant vs multi-tenant, uniqueness of the building), a typical CRE appraisal can range from $2,000 to $5,000. Timing is also much longer with the average commercial appraisal in my area taking 3 weeks or more versus a residential appraisal  often taking a week or less.
• Environmental Reports: Different lenders have different requirements but if your CRE loan amount is $1 million or more, you can pretty much bet that a Phase 1 environmental report will be required. This report which addresses potential environmental risks associated with the property, is also lengthy and takes some time. Though not taking as long as a CRE appraisal, a Phase 1 can typically require 1-2 weeks to complete and cost typically ranges from $1500 to $3000 for this report. If it comes back clean, no further work is needed but if the report uncovers potential environmental issues such as soil contamination from historic use of the property or adjacent properties – like that gas station next door or the dry cleaner who used to occupy the building for example, then you could be required to incur further environmental reporting costs which can easily reach over $10,000 if work such as pulling soil samples is required. For loans under $1 million, the lender will normally require a more abbreviated report referred to as a desktop environmental report which often costs $400 or less and, providing that report comes back clean, limits your costs during the due diligence period on a commercial loan.
• Transaction Closing Costs: CRE loans are able to be more customized to suit particular needs of the borrower or lender or to accommodate unique aspects of the property. Because of this, it’s often necessary to have closing documents drafted by an attorney. Most lenders I have worked with will require attorney prepared loan documents for any loan over $1 million. I’ve seen this cost widely vary depending on who the lender engages as their attorney…so be sure to ask up front what they estimate cost to be for preparing loan docs!

The other area that often differs from residential lending is how CRE loans are structured. We usually refer to this as the loan terms. While your typical residential loan can vary with options such as home equity loans, HELOCs, and ARMs…borrowers are typically most familiar with and partial to 15 or 30 year fixed rate loans. These loans offer the advantage of a predictable monthly payment for the life of the loan. They are almost always fully-amortizing — meaning that the loan is paid off at the end of the 15 or 30 year term. While residential balloon loans also exist, they are less common and not typically an option preferred by the average residential investor.

With CRE loans, loan term is often based on the time remaining on the lease in place at the property. So, if you are buying a property with tenants ranging from 3 to 10 year lease terms, you might find a lender willing to issue a 10 year term loan. In the case of loans with leases that are shorter terms ranging 1 to 5 years, you will often be limited to a 5 year loan term. The amortization, how many months the loan payment is spread over, however could be anywhere from 10 to 25 years.This is often referred to as a balloon loan because the remaining principal will be due at the end of the loan term also known as the loan maturity date. In most cases, the lender who gave you the original loan will want to keep that loan on the books providing you’ve paid as agreed and they will be proactive about refinancing before the term ends. If your relationship with the lender was less than satisfactory, you may be seeking a new lender to refinance that remaining balance.

In addition to differences in term and amortization, the down payment requirements on CRE loans are typically much higher. While I’ve seen residential investment loans typically as low as 15% down payment, CRE investment loans typically can range from 25% to 35% down and even higher in the case of special purpose properties (things like car washes, mini-storage, schools, churches, or assisted living facilities, or other buildings with unique construction that can’t easily be converted to a new property type). While there are always exceptions to these rules such as some specialized finance programs that exist for certain apartment communities available through Fannie Mae (I’ve seen them offer as low as 20% down), those loans have other requirements that must be met in order to qualify.

Last but not least…a big difference with CRE loans is loan covenants. Loan covenants on a typical CRE loan include Financial Statement covenants, a DSCR covenant and Right-size covenant.

Financial statement covenants require that a borrower provide some level of financial statements on an annual basis. Most often this includes providing updated rent roll, leases, and property operating statement. In addition, the lender will usually want to see the tax return of the entity that owns the real estate. If the loan is full-recourse, meaning that it required personal guarantees – a very common feature of CRE loans, then you’ll also be asked to provide an annual personal financial statement and personal tax returns.Your lender will reach out on an annual basis to collect this information and refusal to provide it could be considered a default of your loan.

The DSCR covenant which I explain in more detail here helps a lender to ensure that the property is producing sufficient cash flow to service the total annual loan payment while still providing some level of return to the investor.

A right-size covenant is an important one – it states that if a loan fails it’s DSCR covenant, the loan principal will need to be paid down to an acceptable level to get the loan back in compliance with that DSCR covenant. This can put the borrower in a tough position as an under-performing CRE investment property could cost them further money in the form of a capital call from the bank to right-size the loan. While these are not a requirement on ALL CRE loans, they are certainly something to be aware of and look out for as they are much more common on CRE than they are on residential loans. The more important difference I want to highlight here is that while your typical residential loan is set and forget, with a commercial loan, you and your lender will be working together on an annual basis for the entire term of the loan.

There are some compelling reasons for investors to consider commercial real estate (CRE) including:

• Better Qualified Tenants: While there are always exceptions such as startup business tenants, one of the advantages to CRE investing is that often times your tenants are established companies with track records to better prove their worthiness as a tenant. In some cases, the tenants are national companies whose financial/credit information is available to the general public. While these credit tenants typically command lower rental rates and thus lower returns than smaller mom & pop business tenants, they also provide a more certain income stream for the investor. Even outside of credit grade tenants, an investor can do some easy online research to learn more about the business they are considering as a tenant.
• NNN Leases: In the case of many single-tenant retail or industrial buildings and also some multi-tenant retail and industrial, there exists a common lease type referred to as triple-net or NNN leases. In this type of lease the tenant is responsible for paying the cost of property tax, insurance, and maintenance costs of the property. By requiring the tenant to cover these expenses it mitigates much of the uncertainty typically associated with real estate investments. Often times, NNN leases provide the added advantage that it sometimes makes the tenant more sticky…they are less likely to vacate a property which they have some capex invested in.
• Longer Lease Terms: With the exception of multifamily leases which are typically annual and sometimes month-to-month, most commercial properties feature longer term leases than residential properties. Lease can range anywhere from 1 or 2 years up to 20+ years. It is quite common for these lease agreements to include annual increases or “lease bumps” which are justified as keeping up with inflation. One of my most successful industrial investor client’s typical lease terms are 5 to 10 years, triple net with 3% annual rent bumps. As a lender, I love seeing a NNN lease with annual bumps as it helps to improve the loan’s DSCR over time.
• Potentially Easier to Increase Value: While any real estate value, commercial or residential, is based on factors like location as well as local supply/demand metrics, the value of CRE investments is based mostly on the net operating income or NOI that the property generates. So, by increasing rents over time and controlling expenses, you can increase the value of the property. Recalling the calculation for cap rate also known as IRV, we know that INCOME divided by RATE = VALUE. So for example, if you take the NOI of a CRE property and increase it from $150,000 to $175,000 and that property type has an average cap rate in your market of 6.5%, then the value using the income approach would have increased from around $2.3 million to $2.7 million.

Does this mean that CRE is a better investment option than residential? Not necessarily. There are advantages to both options and residential investment can be a lucrative option for new as well as seasoned investors. But hopefully this article has been helpful to outline the differences in CRE loans versus residential as well as some of the advantages of CRE as part of your investment portfolio. The important thing to remember is there’s no one investment type that will work for everyone and each individual investment needs to be analyzed on a case by case basis before making a final decision. So now that you’ve been equipped with some additional knowledge, happy hunting for that next ideal investment property!