How much equity is required for different types of CRE deals
The idea of a “down payment” on a piece of property is simple in residential real estate. You put down some amount of money, and borrow the rest from a lender. Your income, net worth, and potentially some non-financial factors will determine the down payment percentage required.
In commercial real estate, many deals start with the same basic principle, but there are several ways it can get more complex. Many deals are done with more structure in the capital stack, such as an equity partner or a mezzanine lender providing funds for higher leverage. But ignoring structured finance scenarios for a moment, how much equity is required if you’d like to buy a property utilizing a commercial mortgage?
The answer is a spectrum, and we’ll walk through the most common points along it. Note that some of these points refer to characteristics of a deal, and some to a type of lender. That’s because there’s correlation between the two.
Land not planned or approved for a specific income-producing use is not highly desirable asset to lend against, and for that reason, has a relatively low potential leverage point. This means that to own raw land, you’ll need to provide more equity relative to the appraised value.
If a lender provides too much capital on a piece of raw land, they are relying on a borrower’s other income and wealth to make payments, since the land itself doesn’t generate income. If the borrower falls on hard times elsewhere within their financial portfolio, they’ll be at risk of missing loan payments. Therefore a lender will “play it safe” with raw land.
The term Speculative here means that a real estate developer takes on a project without any guarantee that the asset will generate revenue once completed. This could end badly if there is no demand for the property once complete, whether that be an office building without any companies that want to work there, or a hotel that can’t fill up its rooms regularly. Another risk is running over budget and not being able to complete the asset without additional funds injected. As such, lenders will look closely at the relevant experience of the borrower in executing such construction or rehab projects, and typically require more of the borrower’s own equity as “skin in the game”.
Life Insurance lenders are known to fund stable, cash-flowing properties for strong borrowers at relatively conservative LTVs, think 65%. Of course, there are other lenders that compete in this space, and different life insurance companies can provide higher leverage. But we’ll call this point on the spectrum Life Insurance based on what is typical.
The other defining factor here is that you can get a long-term fixed rate (more than 10 years), while that typically would not be available if you are putting in less equity.
Along with agency lenders Fannie Mae and Freddie Mac, large banks and CMBS lenders can approach and reach 80% LTV for stabilized properties with strong cash flow. This is typically the highest leverage point you’ll see for a cash-flowing commercial investment property, with $4 of debt for every $1 of equity. Any less of a cushion would be deemed a risky loan for a financial institution to make.
Ah, the mythical 100% financing deal. This is possible when developing a property that is already pre-leased to a single credit tenant that pledges to cover the taxes, insurance, and maintenance upon completion.
So by now hopefully you see that there is no single maximum leverage point possible for any commercial real estate deal. A couple of closing thoughts: