By Robert Newstead
What is commercial real estate finance?
Commercial real estate finance is the backbone of the real estate industry. Commercial real estate financing is effectively arranging the capital stack in a way that owners or developers of multifamily and commercial real estate can optimize their debt and equity levels when acquiring, refinancing, or developing a property.
An overview of the different types of loans for multifamily and commercial real estate
Permanent loans are those loans that you can obtain for existing buildings that have already been stabilized from an operations standpoint.
Permanent loans offer borrowers a fixed interest rate for a set amount of time, and these loans are often quoted in 5-, 7-, and 10-year terms. The most popular amortization periods for the loans, which means that amount of time provided to pay down the principal loan amount are 25- and 30-years. Amortization periods depend on the asset type, the location of the property, the age of the property, and the lender type.
Lenders are generally looking for debt service coverage ratios (DSCR) on a permanent loan for commercial in the 1.20x to 1.30x range and above, and on multifamily loans, we have seen lenders looking at 1.15x to 1.25x debt service coverage ratios.
Permanent loans for multifamily can be arranged with the Agencies, banks, life insurance companies, and CMBS lenders. Permanent loans for commercial properties can be arranged with banks, life insurance companies, and CMBS lenders. Bank lenders cover a wide range of banks from international money center banks, regional banks, local banks and also credit unions.
Another type of financing that is available in the market is bridge financing. Bridge financing is usually provided by banks or debt funds.
Bridge loans typically offer shorter loan terms that can either have a fixed interest rate or a variable interest rate interest. Bridge loans are most often used by borrower that are acquiring or refinancing a property that is in some sort of transition. The transition can be that the property is being re-tenanted, or re-purposed, or a property where the accounting needs to be improved upon or the management needs to be improved.
There’s a whole host of reasons why you would get a bridge loan as opposed to a permanent loan. Bridge loans are usually flexible in nature in that they are in place for a short time period, the lender will often times provide additional loan dollars to complete the business plan and/or to improve upon the property, and these loans have repayment flexibility so that you can either sell the property or replace the loan with a permanent loan once the business plan has been achieved.
Construction financing is debt financing for projects that need to be developed. These loans are also referred to as ADC loans, which stands for Acquisition, Development, Construction loans.
Construction financing for projects is usually provided by banks, life insurance companies, high yield debt funds, and FHA/HUD for multifamily apartment complexes.
If the developer is solely looking to buy land, they will mostly need to work with bank lenders or high yield debt funds depending on the location and whether the property is entitled or not. High yield debt funds will finance unentitled land while most other lenders shy away from that particular asset class.
Construction financing enables developers to move from construction financing to completion of the project, and then typically allows for a tail on the end of the project to provide the developer with time to lease up the property. The tail on the end is necessary for a developer so that they have a time cushion, so that they can lease or sell the property.
Loan terms from various lender types have historically been consistent during normal times. During recessions and pandemics, lenders become more conservative because lenders are all about limiting their risk and exposure to losses. Loans historically have been readily available in the 60% to 80% loan-to-cost range. In 2021, we are now regularly hearing that loans for construction financing are in the 45% to 60% loan-to-cost range. Loan-to-cost varies based on the lender, and now more than ever, it is imperative to go out to a wide range of construction lenders to obtain quotes. This is because lenders have changed their perspective and lenders that previously offered higher loan-to-cost loans may be on the sidelines currently, and lenders that were not in the construction financing market previously may be offering some construction financing to obtain yield.
Interest rates can be very low especially with bank financing. Banks have been offering construction loans in the LIBOR plus 300 to 500 range. High yield debt funds may offer construction rates as low as 7% with additional lender fees on the front end that are usually 1-3% of the loan amount.
From an underwriting standpoint, lenders underwrite future debt service coverage rather than in-place debt service coverage especially since there is no income on the property during the development phase. Lender will also look at land value, constructions costs, and expected future value.
Construction lenders generally want to see the construction period concluded within 12 to 36 months, and then anticipate that the developer will have the loan paid off at the end of the loan term with a takeout loan or through a sale. Life insurance companies may offer a construction to permanent loan option after the initial 2 to 3 year development period, and would then look to have the loan convert to a permanent loan once the property is generating a debt service coverage ratio typically of 1.25x on an amortizing basis.
There are also loans called construction-to-perm loans. Construction perm loans are most readily available for multifamily from life insurance companies and FHA/HUD. There are also life insurance companies that will provide construction perm loans for other commercial property types, however, they are not as common as the ones available for multifamily.
Construction-to-perm loans provide a fixed interest rate during the construction period and then carry that interest rate forward into a permanent term loan. These loans may have a 12-year term that covers 2 years of development that then converts to a 10-year loan upon lease up at a fixed interest rate.
Construction financing is usually readily available except in extreme circumstances when lenders decide that there’s either too much supply, or there’s some sort of financial meltdown like in the great recession of 2008, and even now during the COVID-19 pandemic. During disrupted time periods, there are generally fewer construction lenders available in the market.
During the COVID-19 pandemic, many lenders have indicated that they are willing to lend on projects, because they recognize that the development time period will be for a 2- to 3-year time period, and most lenders anticipate that the pandemic will be addressed by then.
Hard Money Loans
Yet another loan that we can talk about are hard money loans. Hard money loans can be used for a whole host of things, but are typically used for properties that have a more challenging story. There are times when a property may need to have a complete re-positioning that other lenders are uncomfortable with. There can also be situations where borrowers have had foreclosures or bankruptcies that other lenders may not be willing to entertain. Hard money lenders will often times look at financing unentitled land. These loans are also flexible and have quick closing timeframes, so these loans are not solely for challenging properties or borrowers. Many high net worth and ultra high net worth borrowers strategically use hard money loans due to the flexibility and quick closes. These borrowers may use these loans as a cheaper alternative to equity.
This has been a brief overview of multifamily and commercial real estate finance. We hope that this has been helpful in providing an overview of permanent loans, bridge financing, construction loans, and hard money loads. Now that we have discussed these loan types, the next blog article will cover what a financial intermediary is and what the role of a financial intermediary with respect to multifamily and commercial real estate.