Commercial real estate means office buildings, retail and industrial properties, multi-family projects and the raw land that eventually becomes all of the above. Commercial real estate financing is equally varied and includes everything from traditional bank-backed loans to newer twists such as crowdfunding.
There are a variety of sources of lending, particularly for borrowers or projects that wouldn’t qualify for traditional bank loans. Some of those are institutional lenders such as hedge funds, life insurance companies and pension funds. There are funds that work with distressed properties, such as those properties that lost significant value during the economic downturn, and there are private lenders, sometimes referred to as hard money, according to Jackie DeLaney, president and COO, Atalyst Commercial Mortgage.
Reasons for finding nontraditional funding are as varied as the types of nontraditional funding. Risk is one, speculation is another. Banks aren’t allowed to speculate but individual investors can.
“Maybe it’s a speculative purchase where we’re going to buy that piece of land, hold it for three years, and when a freeway comes through that property will rise from $10 million to $18 million, let’s say, because now it has freeway access,” said Robert Anderson, partner, Snell & Wilmer. “Or maybe it’s way out of town and you’re waiting for town to move toward that piece of land. You need to have people that are willing to take risks and those are investors and sometimes they’re pension funds, it might be a profit sharing fund, a legal practice or an accounting practice or a medical practice where they have excess cash and are looking for investments.”
There may be a lot of sources, but mixing and matching them to borrowers and projects can be challenging post-recession. Not only is it a lot more work to find the right financing for the project, but it’s not status quo, said DeLaney. “Different lenders have different criteria. There was a day when you could pretty much guess that this type of property would get a certain type of loan. It’s not like that in today’s world.”
Every project is different and every lender is different. Some projects require extra equity from the borrower in order to secure financing in addition to debt financing (borrowing the funds without giving up ownership of the property). Others require equity financing, selling an interest in the property or a share to the investor; the borrower gains funds but loses some control.
Even if the borrower is interested in a traditional bank loan, preferences don’t always matter. “Banks want to lend, but there are so many restrictions now and changes in regulations that it’s difficult for them,” said DeLaney.
Added to that, there are projects that traditional banks traditionally don’t touch, like financing raw land. One option for land financing is lot or land banking, where a partner steps in and purchases the land the builder wants to develop. The purchase price becomes the equity funding to secure financing, and the builder has an option guarantee to buy the land from the partner. “That price creates a yield of return to that land banker or lot banker,” said DeLaney.
Borrowers seeking long term permanent financing probably won’t go with a bank. For a 10 year or longer fixed rate financing nonrecourse loan, they’ll probably look to a life insurance company, which can go out as long as 30 years.
“Ninety percent of our clients want a life insurance loan,” said Adam Gregory, vice president, CommCap Advisors. That doesn’t mean they’re going to get it, largely because of values of properties today versus values of properties 10 years ago. Clients call wanting flexibility on prepayment and a laundry list of requirements that fit a life insurance company loan but their numbers show they need a 75 percent loan to value, market cap rate (ratio of net operating income to property value) and everything that falls into the commercial mortgage-backed securities (CMBS) side of things.
CMBS loans tend to be longer term than traditional bank loans. They’re also nonrecourse loans, meaning the borrower isn’t personally liable for the loan unless he commits certain acts such as fraud or bankruptcy. New regulations just taking effect in the CMBS market are causing some turmoil, said Gregory, with the result that some lenders have left the Nevada market.
Show Me the Money
When a borrower doesn’t own the building yet, their equity contribution has to come from somewhere. Some borrowers use their own capital, then work with mortgage brokers and commercial mortgage and investment banking firms to secure debt financing to make up the rest of the funds needed.
Other times the borrower comes in with an investment group. Analysis on the deal will then show if the borrower has enough equity to acquire the property or if they need more equity and if so, what’s the best way to finance it. That might mean bringing in a partner or looking for preferred equity (an equity investment in the entity that owns the property), or mezzanine debt (usually a loan structured by a lien on the property).
When the buyer doesn’t have the money or the banks won’t loan because a project is too speculative, one solution is to form a partnership or LLC and sell units of interest, or equity, to investors. That’s not a typical way real property is financed, but it’s a typical way real property is financed in specific situations, said Anderson.
Traditionally banks consider cash flow coming off a performing property, maybe a building that’s leased up and producing rents. If cash flow or rents, less operating costs, is sufficient to cover principle and interest payments on the building, the bank will probably loan.
If the property isn’t performing, or is distressed, the borrower can use a joint venture to raise funds. In the case of a $10 million building purchase, said Anderson, if the buyer has $3 million and the bank is only willing to loan $5 million because rents are not sufficient, then the buyer needs to raise another $2 million. The joint venture allows investments in the LLC until a larger equity payment is met. The bank can then provide financing for a smaller percentage of the amount, which can be serviced by the rents on the property. Then the borrower/owner can gradually get rents up or lease more, and eventually refinance.
Even amongst nontraditional financing there’s nontraditional financing. Nevada State Development Corporation (NSDC) is a nonprofit that handles the processing, packaging and servicing of Small Business Administration (SBA) 504 loans, according to Debra Alexandre, Nevada director. The organization works primarily financing long-term fixed rate assets.
Working with owner-occupied buildings, not investment properties, NSDC partners with banks, which provide 50 percent of the financing on a first deed of trust on the real estate. NSDC, with the SBA, provides up to another 40 percent, for 90 percent financing. The small business owner who’s buying or constructing needs to supply 10 percent equity.
“The standard, conventional market would be anywhere from 60 to 75 percent market value, so it allows the small business to keep more of their working capital in the business rather than use it for an equity injection to buy the building,” said Alexandre.
The reasoning behind the program is economic development. The program finances buildings for businesses that are growing and will create jobs in the future.
NSDC can also refinance existing loans. “It really assists small businesses in a number of ways when we can refinance a commercial real estate project for a small business owner at today’s current interest rate which, in our program, is less than 4.5 percent right now,” said Alexandre. For those owners who purchased pre-recession at 7 or 8 percent, and who may be underwater, that’s a significant savings.
Many of those loans were maybe amortized over 20 or 25 years but mature in 10 years, at which point the bank then looks to renew that loan, said DeLaney. But if the property has lost value, owners may have to come up with additional cash or collateral to meet the 60 to 75 percent loan to value ratio banks are looking for.
Often NSDC can refinance with the 504 program up to 90 percent, either minimizing or eliminating the need for additional cash or collateral, a significant benefit for small businesses still recovering from the recession.
Angel investors are another source of non-bank financing, but they’re more likely to invest in businesses than property. However, unique financing sources are also beginning to emerge and options like crowdfunding are becoming more and more popular.
Making Matches Online
Like finding dates online and the rise of project funding sites, commercial real estate financing is turning to crowdfunding.
The historic challenge of finding investors for CRE projects was the inability to legally solicit investors outside personal and professional networks. The potential pool of investors was limited to friends, family and former clients who might spread the word.
In May of this year, the Securities and Exchange Commission voted to allow crowdfunding to raise up to $1 million annually from unaccredited investors, meaning households with a net worth less than $1 million or annual income of less than $200,000.
Federal crowdfunding sites online create the intermediary borrowers that investors are required to work through. There are thresholds for the amounts raised that determine whether SEC documentation has to be filed, but in addition to possibly avoiding tortuous documentation, the sites provide investors information on investment opportunities and borrowers the chance to reach huge pools of interested investors.
It’s too soon to say how the new portals will be used, but crowdfunding is happening. “It has increased tenfold from five years ago,” said Gregory. “I have clients that have done it, gone out and crowdfunded the equity for their projects. Most lenders don’t have an issue with it as long as their guarantor meets all requirements they’re looking for. I talk to people on a weekly basis out there doing it, raising money to buy property – they thought perhaps they could get to that 70, 75 percent loan to value, but based on current market conditions they’re having to raise an additional 5 percent [to get financing] and rather than dipping into their own pockets, they’re out there raising that money with crowdfunding.”
As the commercial real estate market begins to grow again, CRE projects are being funded in a variety of ways, depending on the project. For an owner-occupied property the best choice might be the SBA 504 Loan Program because of the lower down payment and below-market interest rate on the SBA portion.
“But it is a long-term, fixed rate program, so there might be some conventional programs that might be a better fit for [businesses] if they’re planning to only keep that property a year or two,” said Alexandre. Financing slightly larger projects through some of the major insurance companies would probably be a good plan for owners intending to retain ownership for a significant period of time.
A borrower may go to a bank for financing to secure limited to no prepayment penalty and more flexibility in terms in a five year loan – which is what most banks want to lend, said Gregory. Most don’t want to go past five years and their fixed rate might be 4.5 to 5 percent. “We’re doing 10 year fixed rate loans with life insurance companies right now at 3.5 percent.”
It might be a life insurance company coming in on a cash flow income property or a hedge fund that will take a risk on a property that hasn’t quite stabilized and do a loan for a period of time and call it a value add type of financing, said DeLaney. Interest rates have gotten higher, even with life insurance companies and banks but the rates still make sense. Life insurance companies and pension funds for the most part want properties that are performing and creating cash flow.
“Everything else just kind of falls into a category of you have to figure out how to finance it,” said DeLaney. “Its not just cut and dried.”