Why do you get a higher or lower rate from a lender in commercial real estate? Here's why.
There are several factors which will affect the rate of your commercial mortgage (loan for commercial real estate). While the underwriting practices of lenders vary, there are several key factors that will determine which lenders are your best bet, and how competitive your rate will be. It all comes down to a spectrum of risk — the less risk in lenders’ eyes, the lower your rate is going to be. Lenders evaluate potential loan deals based on a combination of sponsorship, market, asset financials, and loan structure.
Without further ado, let’s jump in!
The first factor is sponsorship. In commercial real estate, the “sponsor” is the lead investor who owns the project, so in this case when talking about the loan, sponsor is interchangeable with “borrower”.
The sponsor’s track record for commercial real estate projects is a key factor in a lender’s decision whether or not to lend, and when more lenders want access to your deal, competition will help you get the best rate. Showcasing a history of success as a sponsor will make it more likely that you’re able to obtain a favorable commercial mortgage. When first connecting with a new commercial lender for your project, make sure they understand your track record.
Often the borrower’s personal finances will also play a role in determining the available financing. How big of an impact personal finances play in the lender’s risk assessment of the deal will also depend on the sponsor’s track record, and whether or not the loan requested is Recourse or Non-Recourse (see our previous post Recourse Refresher if you’re not sure about this distinction).
Alright, the lender is comfortable with the sponsor who is requesting the commercial mortgage. But are they comfortable with the market?
When a lender refers to the “market”, the general backdrop is always the economy. If the economy is in the gutter, it will be harder to get a favorable loan rate. Interest rates like US Treasuries and LIBOR also play a strong role in determining rates, not only for floating rate commercial mortgages which are literally tied to those indices, but also for fixed rate commercial loans because they affect the lender’s access to capital.
Zooming in, the lender is also going to look at the local market where the borrower’s project resides. Is the city population growing where this sponsor wants to build an apartment complex? Will the local economy in that county support a shopping mall in years to come? The lender wants to be sure that the local market has strong demand for the type of real estate they are lending against.
Continuing on the lender’s thought pattern, they typically don’t feel comfortable blazing new ground in their underwriting. They’ll want to know what market comps support a property valuation, and how the market is valuing the asset’s discounted cash flow (cap rate). The property’s value (current and projected) is the core basis for a lender’s analysis of a potential loan.
Except for a new development deal, the first numbers that a lender will look at will be in-place financials. A great indicator of the future performance of an asset is the past performance of the asset. If the existing financials are solid, the rent roll is strong, and not much work is required to keep it that way, then the lender will say things like “the asset speaks for itself”, regardless of sponsorship.
A pro forma analysis is a forward-looking prediction of the asset’s financials. The pro forma is typically rooted in historical performance, then adjusted for risk factors, improvements, change in rents, and other factors. It’s important to start with a well-formed, logical forecast of how much Net Operating Income the asset will produce over the life of your loan.
If you have a well-formed pro forma, lenders may use it as a starting place when running their own analysis of the deal, trying out different assumptions and applying their own risk assessment. Lenders don’t have a crystal ball, but they do have analysts, and they will use them.
The “LTV”, or Loan-to-Value ratio, is a key metric for comparing the size of the loan to the value of the asset. The higher the LTV, the more risk the lender is taking on with the deal. Lower LTV deals will tend to be easier/cheaper financing.
These two term-sheet items determine how the lender is paid back if the asset’s operating income isn’t enough to cover the loan payments. The typically collateral of the loan is the building and property behind the loan. Recourse refers to the sponsor’s commitment to personally pay back the loan if there is still an amount due after default (and after collateral is taken). More on Recourse in our previous blog entry: Recourse Refresher.
Commercial real estate loans can be both very large, and very complex. Often as deals climb the ladder of size and complexity, you’ll start to see more custom provisions to satisfy the lender enough to put out their money. Custom provisions can relate to outcomes of leasing negotiations, changes in operating income, or any other asset-specific stipulation.
Now knowing the factors that will affect your commercial loan rate, how do you find out the rate, structure, and terms of the ideal loan on your own project? Lucky for you, we’ve focused on exactly that problem in building StackSource — the online platform for commercial real estate loans. Through our web platform you can enter project details and attach your financials, to be instantly matched with top lenders that will review and respond to your loan request. You’ll get real-time email alerts as those lenders respond with real loan quotes tailored to your deal. You can then negotiate with those lenders and select the best financing for your project. Learn more about StackSource today!