Asset types

Financing Commercial Real Estate Deal with Mortgage

In this article we discuss the basics of financing commercial real estate deal with the use of senior or mortgage financing.  

As an investor, your understanding about how to finance a deal is equally as important as finding one. Understanding the breakdown of financing for the deal provides you with insight for all costs involved in obtaining financing. You should make sure the sponsor did include all relative expenses in the underwritings.

The costs of financing commercial loans are generally higher than for residential loans. In addition to higher interest costs, commercial real estate also involves higher fees which add up to the overall cost of financing. These fees would include appraisal, legal, application, origination and survey fees. Some of these fees will be paid up front before the mortgage is approved or rejected, while some may apply annually.

The most important terms of the loan to look at are:

* One of the most important terms is LTV, Loan-to-Value ratio. LTV is a portion of the property’s purchase price that the bank will be financing. Banks would often be willing to offer financing of 75 to 100% of the value of commercial real estate, depending on the building’s condition, financial strength and so on. A higher LTV means that less money is invested up front from investors as a down payment. The cost of bank financing will always be lower than the cost of investors’ capital or bridge financing providers. Thus, the higher the LTV the higher the overall return on your investment should be. Of course, the higher the LTV the higher also the payments for the loan, the sum of interest and amortization.

For example, say you are considering investing in a commercial building which sold for $10,000,000 and you have similar offers from two different banks: One is offering 80% LTV financing and the other 90% LTV financing with the same level of interest of 5% and amortization of 25 years. If you check the mortgage calculator, the full payment including interest and amortization for a $9,000,000 loan (90% x $10,000,000) is $638,500 per year and for an $8,000,000 loan, the full payment is $567,600. This is a $70,000 difference in net cash flow distribution.

It is important to play with different LTV levels to come up with the optimum financing level which would maximize the returns. However, in that case the most important limitation to keep an eye on is DSCR ratio (debt service coverage ratio). This is a ratio used by banks to measure the financial strength of a property. In other words, is the cash flow of the property sufficient for the provided level of financing so that there is a low risk of default on loan payments? DSCR is calculated standardly by dividing Net Operating Income by the full debt service and is usually presented as a percentage. The usual requirement from the bank is to have a DSCR which is higher than 120%.

Generally, the higher the DSCR the stronger the financial position of a property and thus the more debt the property can take on. For instance, imagine that the annual NOI for the property above is $700,000 per year. Now check a DSCR for each of the cases: 90% LTV and 80% LTV. In the first case the DSCR is 110% while for the second case the DSCR is 123%. Thus, the property would realistically be able to afford only 80% LTV mortgage.

* A second key variable is an amortization period. In a commercial property loan the amortization usually varies between 15 and 25 years. The longer amortization period might be preferable for both an investor and the bank. For the investor, the longer the amortization period the lower the quarterly payments to the bank and thus the higher the net cash flow distributions. For the bank, the longer the amortization period the longer you pay interest (theoretically) and thus the higher their earnings.

* The last extremely important consideration for a mortgage is the bank’s flexibility in terms of loan repayment and prepayment. For instance, banks are often willing to offer interest-only periods on their loans. These are amortization-free periods which allow investors lower payments for a specified period of time, from 1 to 2 years.

The interest-only loan periods are especially helpful for value-add opportunities where there is significant amount of cash required at the beginning of the investment and often the property might not generate enough cash for debt service coverage. Additionally, the bank’s flexibility about repayment and level of related fees are very important. Rarely would any investor in the market hold the property in their portfolio for 25+ years. Thus, the possibility to repay the loan earlier with the lowest fees possible should be considered when planning on signing a mortgage.

Let’s review and look at an example of how the level of your down payment would impact your returns. Imagine you are looking at an offer for an apartment complex with an offering price of $11,000,000. There are 3 financing options available on the market with 50%, 70% and 90% LTV and the same cost of financing. Thus, your down payment would be either $5.5 million, $3.3 million or $1.1 million. The interest rate is 5% and amortization period is 25 years. The annual payment on a loan would depend on the level of LTV:

For 50% LTV the amount borrowed would be $5.5 million and annual payment $390,000.

For 70% LTV the amount borrowed would be $7.7 million and annual payment $546,000.

For 90% LTV the amount borrowed would be $9.9 million and annual payment $702,000.

Let’s assume the annual NOI a property is expected to generate is $1.0 million a year and let’s ignore asset management fees and capital expenses which would decrease the level of NOI. And let’s assume the projected resale price for the property is $14 million with a holding period of 5 years. The net property cash flow in all three scenarios will look as follows:

For 50% LTV: $1.0 million – $390,000 = $610,000

For 70% LTV: $1.0 million – $546,000= $454,000

For 90% LTV: $1.0 million – $702,000= $298,000

Now let’s see the return on all three of the financial structures.

For 50% LTV:

Net cash flow during the holding period: $610,000 x 5 = $3 million

Net proceeds from sale: $14 million – $11 million = $3 million

Initial investment: $5.5 million

ROI: ($3 million + $3 million) / $5.5 million = 109%

For 70% LTV:

Net cash flow during the holding period: $454,000 x 5 = $2.3 million

Net proceeds from sale: $14 million – $11 million = $3 million

Initial investment: $3.3 million

ROI: ($3 million + $2.3 million) / $3.3 million = 160%

For 90% LTV:

Net cash flow during the holding period: $298,000 x 5 = $1.5 million

Net proceeds from sale: $14 million – $11 million = $3 million

Initial investment: $1.1 million

ROI: ($3 million + $1.5 million) / $1.1 million = 409%

As you see there is an enormous difference in the level of returns caused by the difference in LTV level. Now let’s see if the property can actually support a 90% LTV level. What if the bank requires 120% DSCR covenant?

For 50% LTV: DSCR = $1.0 million/ $390,000 = 256%

For 70% LTV: DSCR = $1.0 million/ $546,000= 183%

For 90% LTV: DSCR = $1.0 million/ $702,000= 142%

In that case the level of cash flow generated by the property must suffice even for 90% LTV so an Investor should feel comfortable about going for a higher LTV.

The additional budget must be set aside for the purposes of covering loan origination fees, legal and survey fees and the appraisal fee. The appraisal will be ordered by the bank but paid from the pocket of investors. The following fees with their respective amounts should be budgeted by a sponsor:

Upfront Fees

Some of the fees incurred are upfront fees which a lender must receive before they provide actual financing.  This means that regardless of whether the loan is granted or not, the fees must be paid. The total for these fees can range from anywhere between $500 and $25,000 depending on the size of the loan. The purpose of upfront fees is to cover the due diligence expenses of the bank while processing a loan request. Make sure that a sponsor provides you with a comprehensive breakdown of the fees required by the bank so that you can justify those that are not too high and those comparable to what the market is offering. The following upfront fees usually apply:

* Credit Report. A lender would request a copy of a borrower’s credit history, in that case a sponsor. By ordering the report, a lender is trying to determine the creditworthiness of a borrower. The cost of the report is around $15 – $30.

* Appraisal. A lender would typically order a full appraisal report from one of their partners or a qualified appraiser. Preparation of the report requires deep market knowledge and experience and an appraiser must be a company a lender trusts with the result. A report should regularly be ready in 2 – 3 weeks and cost around $2,000 – $3,000.

* Environmental Report. A bank wants to consider any environmental risk on the site the property is located at. In case of a natural disaster they ultimately lose or have significant damage to their asset and the cash flow it generates, so environmental riskiness shall be on their radar before financing a deal. The same goes for you. The cost of ordering an environmental report could sometimes be higher than an appraisal, from $2,000 to $5,000 depending on the size of the plot.

* Building Inspection Report. The cost of this report would be from $500 to $5,000, depending on the location and property size.

Closing Fees

These are the fees covered at the time of the funding and might be included in the loan amount and amortized over time. Of course, the amount of interest increases as the loan principal increases if those fees are added. The following fees should be included in the underwriting of a property:

* Origination Fee. This is a standard fee paid for the loan opportunity. The fee sometimes is also called an arrangement fee or commitment fee. The origination fee is a percentage of the total loan amount. For instance, if the origination fee is 1% and the loan amount is $2,000,000, the fee total would be $20,000. The fee amount would range from 0.5% to 2.0% depending on the market, but the most common rate is 1% origination fee payable upon closing.

* Commercial Property Insurance. This is protection for both the lender and investor in case of physical damage to the property. The cost would range depending on the market the property is located in and the property value.

* Legal Fee. A lender will require a borrower to cover any legal costs needed to complete the funding. The size of the fee would primarily depend on the loan size. Most of the time, the amount of a legal fee is included in an origination fee.

* Underwriting Fee. This is the fee usually charged by a lender to prepare a loan and all the paperwork engaged in the loan preparation. The fee amount depends on the size, type of loan, and lender’s program. Expect to pay anywhere from $500 to $2,000 depending on the size of the loan.

* Title Insurance. A lender must ensure protection from inadequately performed lien or title searches. The average cost of insurance is in a range of $1000 to $2000 but can be higher for larger properties.

* Broker Fees. Broker fees can be a percentage of the loan, a flat fee, or a combination of both. This fee is not applicable if the investor deals directly with a lender. If the sponsor deals with a lender then this fee would go to the sponsor. Average cost falls between 1% and 2%.

* Closing Fee. A fee paid to the lender for conducting the closing of the transaction. The fee ranges depending on the market and the lender; $3,000 to $10,000 should be set aside.