How to Finance Your First Commercial Real Estate Deal
A frequent question our StackSource team receives from new borrowers is:
“I’ve had many residential properties but this is my first commercial purchase. What do I need to know in order to finance my first commercial property?”
So we decided to give you a simple overview of what you should expect to know when you’re looking to finance your first CRE deal.
- Financing commercial real estate is very different from financing residential real estate.
- Do you have a strong business plan, believable projections, and do you have a strong borrower profile?
- Sometimes a strong extenuating circumstance can still get your deal funded even if it’s out of the typical lending box.
What is your business plan?
- What exactly do you plan on doing?
- Will you be adding value to your asset by raising rents, making capital improvements, lowering operating expenses, or improving the management of your building?
- Do market conditions or your previous experience justify the lenders confidence in your ability to execute your business plan?
Explain this to the lender in a professional manner and make sure they fully understand and buy into your business plan.
Pro forma income
How will this property perform as an asset? Specifically, how much net operating income or cash flow will it produce in the future and what are the certainty of those cash flows?
Lender’s first priority is understanding the asset they will be lending on. Specifically, they will need to know the cash flow from the P&L (profit & loss) of the property. P&L’s generally will include: operating revenue and operating expenses from the asset.
Lenders will usually look at the last two years of annual P&L’s and a year-to-date monthly P&L to really understand the operating history of your property. Lenders will also compare your P&L’s to those of similar assets in the same submarket. This will help lenders compare where your numbers are within the competitive landscape and this will also allow lenders to make accurate projections for your assets future performance.
The bottom line for lenders is determining the certainty of future cash flows. The more certain and attractive your future cash flows are, usually the more attractive your loan terms will be. The more uncertain your future cash flows are, the higher the risk of your deal, and therefore lenders will seek higher returns.
Do you know your numbers?
Here are some important metrics you might get asked about when lenders are looking at your P&L’s and projections:
- Gross revenue — includes rental income, other income (could be from laundry, parking, vending machines, application fees, etc), and subtracts vacancy (usually estimated to be 5% for multifamily properties but this is submarket dependent).
- Rent Roll — an itemized list of which tenants have paid what amount for what space in your property over a certain period of time. In real estate your tenants drive the property’s value, so lenders will need to understand the dynamics of your tenancies and rent collections.
- Operating expenses — includes repairs and maintenance, utilities, turnover/make-ready costs, cleaning, insurance, property taxes, and management fees.
- Net Operating Income (NOI) — this is the property income that’s left over when you subtract expenses from your revenues.
- Debt Yield — This is NOI divided by the total debt amount borrowed. Most lenders will require a certain debt yield in order to lend on your property. The rule of thumb is 7%+ for multifamily, and 8%+ for other commercial assets.
- Debt Service Coverage Ratio (DSCR) — This is the ratio between NOI and your debt service payments for your loan. Many lenders will require a minimum acceptable DSCR of 1.20x for multifamily ($1200 NOI/$1000 debt service payment), and higher for other assets.
Here is our previous blog for a full list of Commercial Real Estate key terms.
How are global and national economies doing? Does your asset class have a strong outlook? Where does region’s economic drivers fit into the big picture?
- Where is the property located?
- Is it located in a primary, secondary, or tertiary market?
- What is the quality of your property vs. competitors in the sub-market?
- What is the population, job growth and median income in that market?
Which third party reports will I need to get?
- Environmental (Phase I & II)
The deal and the type of lender will determine how many of these reports will be required.
Expect the lender to choose these companies and individuals, so don’t pull the trigger too early by getting all of these reports before you have a lender in place. Most likely the lender will make you get these reports from their trusted and approved relationships.
Lastly, expect to pay for these reports as a borrower. Lenders will collect a deposit upon signing the term sheet to use as an expense account.
Track Record and Financial Strength of Borrower
Yes, your strength as a borrower matters with respect to commercial real estate financing. Lenders will want to see that your liquidity is strong enough for you to finance the acquisition. That means whatever the down payment is, you will need to be able to show the cash available to make that down payment whether it’s from you or a combination of you and your partners in the deal.
Some lenders will want to see your credit score, tax returns, and understand your income to help them get comfortable.
Some additional borrower-specific questions could be:
- Is your net worth at least equal to or close to the loan amount requested?
- Do you have a liquidity of at least 10% of the loan request?
- Do you have direct experience and a track record in the business plan? If not, how strong is the team?
- Are you willing to sign recourse? If not, who will sign for carve-out guarantees and (if applicable) completion guarantees? Will it be a warm-body signor or an entity?
Is there more to your story?
This is a more unique aspect.
- Are you a first time commercial real estate buyer after being successful in your field for years having saved up enough money to sink your teeth into your first deal?
- Are you a first time commercial real estate buyer but you come from a family of commercial real estate investors?
- Are you a first time commercial real estate buyer but you’ve partnered with an experienced veteran who will help bring some “grey hair” and experience to your partnership?
All of these are different potential stories that would help the lenders understand why and how you’re purchasing this asset and potentially help them feel more comfortable lending to you.
Good luck out there friends.
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