It is easy to focus on interest rate when choosing a commercial mortgage for a retail, office, industrial or multi-family property and miss other provisions that affect the borrower financially. Here are five issues to consider that can make a commercial property loan with a slightly higher interest rate the better deal.
- Restrictive Prepayment Penalty – In general, the more restrictive the prepayment penalty, the lower the interest rate. Commercial property loans generally have one of three kinds of prepayment penalties – Step Down, Yield Maintenance or Defeasance. Step down prepayment penalties are fixed penalties expressed as a percentage of the loan balance being repaid. The percentage drops every year or two. For example, for a five year fixed rate loan the prepayment penalty is often 5% in year 1, 4% in year 2, 3% in year 3, etc. Yield maintenance and defeasance penalty calculations are complicated but their objective is to compensate the lender more fully for the lost interest income that would have accrued had the loan not been prepaid. Step down prepayment penalties almost always result in a lower penalty than yield maintenance or defeasance, except in situations where interest rates are increasing – in which case the borrower is less likely to want to prepay the loan. More often, a yield maintenance or defeasance clause will make it cost prohibitive to refinance prior to loan maturity. Unless the borrower is certain they will not need to refinance or sell the property prior to loan maturity, they should consider paying a slightly higher rate and having the flexibility of a step down prepayment penalty.
- Short Amortization – Commercial mortgages most often have an amortization of 25 or 30 years, although, shorter and longer amortizations are not uncommon. The amortization has a big impact on the monthly payment and hence the cash flow from the property. A $1 million dollar loan with a 25 year amortization and a 4% interest rate will have a payment roughly $500 greater than the same loan with a 30 year amortization. If the borrower is looking to maximize free cash flow from a property, a higher interest rate on a 30 year amortization may be a better fit than a lower interest rate on a 25 year amortization.
- Required Impounds for Insurance and/or Taxes – Some commercial real estate loans require impounds for insurance and/or property taxes. The lender collects an amount each month sufficient to make the insurance and tax payments when they come due. The borrower is therefore paying the insurance premiums and taxes well in advance of when they would otherwise. In effect, they are making an interest free loan back to the lender.
- Loan Term With Narrow Refinance Window – Commercial real estate loans either come due at the end of the fixed rate period of they convert at that time to a variable rate loan. The latter are often referred to a hybrid loans. For example, a hybrid loan may have a fixed rate of interest for 7 years, after which the loan converts to a variable rate loan. Other loans have fixed terms equal to the term of the fixed rate. In the above example, the rate would be fixed for 7 years and due in 7 years. The rates on hybrid loans are a bit higher. But they offer more flexibility as to when the borrower refinances. A loan that becomes due at the end of the fixed rate period may force the borrower into refinancing at a time when interest rates are up or there are other issues with the property or the borrower’s finances that make refinancing difficult.
Commercial real estate loans on apartment properties can be tailored to satisfy a variety of borrower needs. However, borrowers are often frustrated by hearing “no” from the first lender or two with whom they speak. They may then assume their need cannot be met and may settle for a new or stay with an existing loan that does not fully meet their needs.
Getting to “yes” is possible – but it requires identifying the lenders best suited to the situation and then approaching them in the most effective manner. The latter is critical, as once a loan package has been reviewed by a lender’s internal staff and rejected, it is often very difficult to get them to reconsider, even when the basis for the rejection can be shown to be incorrect or easily mitigated.
Here are examples of situations where “yes” is possible with the right approach to the right lenders.
- Credit Challenges – Borrowers with less than perfect credit – late mortgage payments, loan modifications, foreclosures, short sales, BKs, low credit scores, tax liens, etc. – can often be accommodated. Lenders look positively toward borrowers that “hung in there” and worked their way through difficult situations. Rates may be a little higher than the lowest available apartment loan rates, but still attractive and significantly lower than those from private or hard money lenders.
- No Prepay Penalty – Some borrowers are unsure about their future plans for an apartment property and want to avoid incurring a large prepayment penalty should they sell or refinance. But they still want the peace of mind that comes with having a fixed rate apartment loan. Five and seven year fixed rate loans are available with no prepayment penalty. The rates are often competitive with similar loans with step down prepay penalties.
- Interest Only – Borrower’s may wish to have a lower payment at the first 1 to 3 years of the loan, particularly on a purchase money loan. The lower payment frees up cash for improvements or to allow time to adjust rents upward as units turn. Some lenders offer a period of interest only payments in the first few years of the loan, generally, for no increase in rate. The difference in payment is significant. For a $1 million loan at 4% on a 30 year amortization, the interest only payment would be roughly $1,400 less per month.
- No Personal Guarantees – Some borrower’s prefer “non-recourse” apartment loans, meaning that in the event of a default the lender’s recourse is limited to exercising its rights related to the mortgaged property or other collateral securing the loan. As such, the borrower cannot be forced to make up any potential shortfall out of other non-pledged assets. Such “non-recourse” provisions have exceptions, often referred to as “bad boy” carve-outs. These carve-outs include situations where the borrower commits fraud, misrepresentation or material omission when applying for the loan or in connection with on-going financial reporting required by the loan, attempts to transfer ownership of the property in manner not permitted under the loan, wastes or abandons the property, fails to remit rents or insurance proceeds to lender to satisfy the loan, or fails to maintain proper insurance on the property. Non-recourse loans were much more common in the past. They are less common today, but they are available.
- Longer Fixed Rate Terms – Many lenders offer commercial multifamily loans with rates fixed for 3, 5, 7 or 10 years. In smaller, tertiary markets, local lenders often offer only loans where the rate is fixed for 5 or 7 years, and then with an amortization period of 25 rather than 30 years. This can be frustrating to long-term holders seeking to lock up today’s low interest rates for as long as possible and/or those who prefer the lower payment of a 30 year amortization. However, there are 30 year amortizing options with rates fixed for 10 to 30 years available in almost all areas of California.
Tiller Hill Capital provides commercial real estate loans for apartment and commercial properties throughout California. We help owners navigate the complex world of commercial mortgages and secure low cost commercial real estate loans to acquire new or refinance
Securing approval of a new commercial real estate loan or multifamily loan is often a challenging process. The problems that delay or derail the process can often be avoided with a little advance planning.
- Start Early. While it is possible to close a commercial real estate loan in as little as 30 days to 45 days, delays often crop up that are not the fault of the borrower or the lender. If your existing loan is coming due you risk not closing before the maturity date of your existing loan. If you are purchasing a property, a delay in securing a loan commitment can cause you to lose the deal. Start shopping for a new commercial real estate loan at least 120 to 150 days prior to your target close date.
- File Income Tax Returns on Time. Many investors routinely file for extensions of Federal Income Taxes. But if you are considering a new commercial mortgage, it is best to finalize your tax returns as early as possible. Lenders look at property financials as reported to the IRS with much greater confidence than interim financials, even if they are prepared by a third party such as a property management firm or a CPA. This is particularly important if you are relying on an improvement in operating results in the most recent year to support the requested loan amount. Lenders will sometimes not want to issue a loan commitment until the final previous year’s tax returns are available. If the property’s income is reported on other than your personal tax return’s Schedule E, then both personal and business tax returns will be needed.
- Review Your Credit Reports. Check your credit report and score with the three major credit bureaus – Equifax, TransUnion and Experian – on a regular basis. There a numerous low cost services available and the credit bureaus are required by law to provide you a copy of your credit report annually upon request. You can request all three for free at www.annualcreditreport.com. Incorrect items show up frequently. Previous liens and judgments, long since paid, may appear as still valid. Clearing up incorrect or incomplete items that may involve writing letters to the credit bureaus and/or the reporting party to request that they update their report to the bureaus. This takes time. For derogatory items that cannot be removed, prepare a written explanation along with supporting documentation and have that ready to provide to lenders.
- Pay Property Taxes on Time. Most commercial real estate lenders will not issue a loan commitment on a property with past due property taxes. If you cannot bring taxes current, see if a payment plan can be worked out with the county. Some lenders will allow payment plans if they are agreed to in writing and you are up to date with the payments.
- Maintain Up-To-Date Interim Financials. Some property owners do not maintain interim year to date and monthly income statements for their properties. Instead, they accumulate records at the end of the year only for tax preparation purposes. Commercial real estate lenders will want to see interim year-to-date and monthly financials for the current year.
- Keep Important Records Accessible and Organized. Keep records such as tax returns, commercial leases, rent rolls, loan agreements, loan statements, interim financial statements and insurance policies in a readily accessible and organized location. For tax returns and leases in particular, make sure you have complete copies. Ideally, have all these documents available in PDF or other common electronic format.
Avoiding these six common issues takes some advance planning, but will help insure your commercial real estate loan process is as quick and hassle-free as possible.
Investors in multi-family properties often overlook agency financing when shopping for small balance ($1 to $5 million) multi-family loans, instead considering only commercial bank loan offerings. In some situations, agency financing from Fannie and Freddie, may be the best choice.
Agency financing offers some unique advantages. First, agency debt offer longer fixed terms. It is possible to lock fixed rates for up to 30 years. Commercial banks usually offer only 10 year fixed rates, occasionally 15 years. Current multi-family interest rates for 30 year fixed are in the 5.25 to 5.3% range. Recently commercial banks have been raising their rates on 7 and 10 year fixed options, causing many investors to opt for more attractively priced 5 year fixed options. Even for investors seeking 7 or 10 year fixed options, lower rates may be available with agency debt. Second, agency debt is generally non-recourse. This is an important consideration for some borrowers. Third, agency debt offers the potential for higher leverage. Loan-to-values up to 80% are possible provided the property satisfies other underwriting criteria, including a minimum debt service coverage ratio of 1.25.
There are some disadvantages to agency financing. First, the transaction expenses tend to be higher. There is often an underwriting fee in addition to the costs of third-party reports. Second, like CMBS loans, in some markets, the collection of replacement reserves may be required, in addition to impounds for taxes and insurance.
Borrowers looking for long-term fixed rates and/or a non-recourse loan should compare agency and bank options to determine which better meets their financing objectives.
Bank underwriting requirements remain very tight, forcing many apartment and commercial property investors to seek financing elsewhere. Over the past several years, the alternatives have been limited and expensive. Rates from private or hard money lenders generally ranged from 9% to 12% and maximum loan to values (LTV’s) were 50% to 55%. Now a new class of lenders has emerged offering more competitive rates and terms. These lenders are offering both permanent and bridge financing with rates starting around 6% and LTV’s up to 75%. Both interest only and amortizing programs are available. Like any lending source, rates and terms vary based on strength of the borrower and the property. But for many investors shut off from bank financing because of credit or other issues, these programs offer an attractive alternative to traditional private or hard money lenders.
Apartment Finance Today, by Les Shaver
As the rest of the economy has foundered, apartment owners have surged coming out of the recession. But the good times might not last forever. Here are eight things that could wreck their joyride.
1. Fannie Mae and Freddie Mac
It’s been more than five years since the speculation about Fannie Mae and Freddie Mac started, yet they remain a vital source of liquidity in the sector, especially in secondary and tertiary markets (where other lenders are less likely to go). “Fannie and Freddie are the most dominant lending sources in our industry,” says John Sebree, director of Calabasas, Calif.–based Marcus & Millichap’s National Multi-Housing Group. “If that is changed, it will have an effect on our values and our ability to finance properties.”
Many owner-occupied commercial properties are financed with SBA loans. Refinance options for SBA loans can be confusing but are worth exploring.
If your loan-to-value is 70% or less, it may be possible to refinance into a lower cost conventional loan. Rates on conventional loans will generally be lower in large part due to the fees that are required for SBA loans.
If you have a SBA 504 loan, prepayment penalties on the debenture generally make refinancing in the first 6 or 7 years not financially viable. Prepayment penalties are applicable for the first half of the term of the loan, declining from year to year. However, it may be possible to refinance the 1st, leave the debenture in place and still achieve significant savings. It will depend on the terms of the first, including prepayment penalties, if any, that may be due.
If you have an SBA 7a loan and your loan-to-value is greater than 70%, it may be possible to refinance into a new SBA 7a loan provided certain criteria are met. These include an improvement in cash flow of at least 10% and verification that the current lender is unwilling to modify the existing loan.
Now is a great time to consider refinancing for both SBA and conventional loans. Rates are near historical lows. How long they will remain this low is uncertain.