It takes money to make money, and real estate is no exception to that rule. Whether you’re just starting out in the industry or planning a multi-million dollar commercial project, you likely need a loan to get things going. This makes getting familiar with lender requirements an important step for any real estate investor.
That said, there is no “one size fits all” when it comes to what lenders are looking for when considering a loan. So we reached out to several area financial institutions about what to expect when seeking a loan. They had plenty to say about the options available and lender requirements for borrowers.
What loan products do you offer the real estate investor?
Loan products are wide ranging and vary based on purpose, market and industry.
“The type of loans that we will grant to a particular investor depends on a number of factors, such as their experience and their financial condition,” said Michael Carnevale, VP, Commercial Banker at Ameris Bank in Gainesville. “We also take into account local market conditions and factors that affect the market segment for which we are considering lending.”
Your options for a single family residence that you plan to flip are quite different than if you’re building or buying a multi-tenant office property. So loan rates, terms, documentation and other aspects will depend partly on the project at hand. Other factors also come into play, such as the investor’s experience and financial condition.
Commercial loans are typically at variable rates with five-year balloon payments. However, fixed rate loans for up to 20 years are also available. Amortization periods are up to 30 years. The loan to value (LTV) generally does not exceed 80%.
How are interest rates determined?
The rate (both percentage and whether it’s fixed or variable) is the result of several external factors. According to Joshua Radeker, Market President at Truist, the nature of your project is an important driver in the process.
“Depending on the scope of a real estate investment project and the objectives of the client, rate structures can be fixed or float relative to an index,” he explained. “Shorter term and construction projects typically bear floating rates, while permanent financing is often tied to fixed rates.”
Exactly what those rates are, however, is tied to the market and the risk the lender takes when providing the loan.
“Fixed interest rates will be determined by prevailing market rates, whereas variable rates are structured to various indexes,” said David Barber, Vice President in Commercial Lending at Campus USA Credit Union. These indexes include treasury constant maturities, the prime rate, federal home loan rates, etc. Barber also stated that the percentage should provide the bank with “an adequate return to the lender based on risk factors associated with the proposed project.”
What are your preferred terms for an investor loan?
As Radeker puts it, “This is not a single answer question.” That said, the responses we received cited some common lender requirements. One basic principle is that the loan terms should reflect the use of the property to help increase the chances that loan payments can be met.
When loaning to finance property that will be leased to a third party, the loan terms will typically dovetail with the terms of the lease. For example, a five-year loan would likely be extended to an investor buying an office building with plans to lease it to a professional for a five-year term.
If you are a homebuilder, you might receive a line of credit that matures in one or two years. Radeker explains that initial payments would be interest only during construction, with the principal paid down when homes and lots are sold. This helps provide ongoing access to cash for the building process.
The goal in all of this is to balance lender profitability with terms that allow the borrower to succeed. As Carnevale puts it, “We are very flexible and will attempt to make sure that the terms make sense for both the investor and the bank.”
Respondents generally agreed that regardless of the project, a loan term shouldn’t exceed 25 or 30 years with a five-year maturity. Carnevale also mentioned a loan to value figure of no more than 75% (and therefore a minimum of 25% down).
What documents do you require as part of the loan application?
You can expect banks to ask for business and personal tax returns for multiple years, personal financial statements and schedule of debts. The number of years for which they want this information varies by lender. They might also require details about the business or property, such as tenant lease terms or historical and current financial performance of the property. Carnevale mentioned that new construction projects would need proformas and possibly a feasibility study.
What loan covenants or other lender requirements are generally included in the terms?
In addition to the term and interest rate on your loan, several conditions (or covenants) are also likely to be required. These can include (but are not limited to):
- Updated financial statements on an annual basis
- Debt service coverage
- CPA-prepared financial statements
- Leverage covenant
These lender requirements depend upon the size and scope of the loan. The larger and more complex the project, the more covenants that will likely be included.
Do you generally provide for loan resets or a balloon payment?
A loan reset is a change in the interest rate that occurs at a set date in the loan. A balloon payment is a large payment due at the end of the loan; this is often done with the intent of refinancing that large payment.
Both options provide an opportunity for you to take advantage of lower rates if they’re available. And it’s an opportunity given on certain real estate investor loans. Loan performance is generally taken into account; the better your payment history, the more likely such allowances will be granted.
It’s not just a benefit for the borrower; Carnevale sees the practice as a good thing for lenders as well. “We do typically provide for resets and/or a balloon payment, which we refer to as loan maturity. The reason for this is to make sure that we have an opportunity to review the loan relationship from time to time and verify that conditions have not materially changed within that relationship,” he said. “Also, the bank generally holds these types of loans on our books, and so we take on the interest rate risk with each loan. A shorter maturity period or periodic rate resets allow the institution to better manage that risk.”
How does the underwriting process work?
This depends greatly upon the lending institution. According to Barber, once you submit initially requested information, that request is sent for formal underwriting. Additional information might be requested during the underwriting process (for example, the additional documentation we mentioned earlier). Once your loan is approved, the lender will recommend terms and structure based on the specifics of the project.
Where this process happens, and how long it takes, can be influenced by the size of the lending institution. However, even the largest banks are granting more autonomy to their personnel outside of corporate offices. Radeker states that with Trust, the underwriting itself is managed by a team of portfolio managers assigned to specific areas. This allows the bank to make the best decisions for their local markets despite the bank operating over 2,000 branches in 15 states and Washington, D.C.
What debt service coverage or other ratios are desired?
Simply put, banks want you to be able to pay your loans. The banking industry rule of thumb on this lender requirement is usually 1.25x. This means that a borrower’s net operating income (NOI) should be at least 125% of the principal and interest of the loan. So if annual loan payments are $100,000, the borrower must have a minimum annual NOI of $125,000.
The actual ratio required once again depends upon local markets, risk tolerance, and the lender’s desire to work with the type of credit extended. Other ratios might also be included for liquidity or leverage.
The Impact of COVID-19
With restaurants, retail stores and more suffering crippling drops in business, the impact has been felt by commercial property owners and investors. Wells Fargo recently published a Commercial Real Estate Chartbook that projected further tightening of financial conditions—which in turn could lead to a pullback in commercial lending.
Thankfully, there is good news. The Federal Reserve has taken steps to help ease the crunch by easing some regulatory requirements. This includes requirements for liquidity, capital, leverage ratio, and some reporting. And a look at prime and treasury interest rates over the last three months has shown little change in either direction, despite the COVID-19 pandemic.
Regardless of the economic climate, applying for a commercial real estate loan takes preparation and research. By arming yourself with this knowledge, you can better understand lender requirements and increase your chances of success at the best rates and terms available.
You can also boost your chances by having a real estate CPA at your side. From financial statement preparation to liquidity/cash flow analysis to financial planning or other services, they’re a vital partner in your quest for funding.
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