How Pricing Is Derived For Commercial Financing: The NEED To Know

For investors that own residential properties and have bought with Fannie and Freddie loans, pricing is pretty easy to determine. Credit score, downpayment, then you shop. Trying to compare residential and commercial is a literal apples and oranges situation. Let’s dive into the factors of how the pricing for commercial financing is calculated.

Introduction

For many investors, the goal of owning a 5+ unit building is on the horizon. Within this community I have noticed that this is a common goal among investors. Today, I want to shed light on how pricing is determined for multifamily buildings and commercial assets as a whole. I will aim to be as concise as possible.

There is a lot to factor in when determining the pricing for commercial financing. I would separate the categories into leverage and loan amount. These categories would be 60-70% LTV, 75% LTV, and 80% LTV. These are the general ranges and leverage caps many lenders place on their loan products. The second criteria is loans below $1mm and loans above $1mm. Some factors to be considered for pricing are metropolitan statistical area (MSA), building condition, borrower liquidity, borrower FICO, building debt coverage ratio (DCR), length of time needed (bridge loan vs. long term debt), borrower experience in comparable deal types, and leverage requested.

Why differentiate between loans under $1mm and loans higher than $1mm? $1mm is the general loan amount that is needed to be able to secure agency (fannie/freddie) lending products for commercial real-estate. I will go into more detail in the paragraphs below.

60-70% LTV Loans

For loans under $1mm, the best rate and terms will be sourced at this leverage point. If you are looking for the absolute best terms, be prepared to be capped at 70% LTV. At this leverage, lenders are comfortable with how much equity and skin in the game the guarantor is bringing to the deal. Usually those people who have funds for 40 - 30% down payment are experienced investors and know what they are doing. This also is a positive for the lender.

From the information above, you can then derive that 75% LTV and 80% LTV will have more unattractive terms. I would like to note that many small balance direct lenders (which are 98% of the time full recourse based) have an LTV cap at 75%, even in tier 1 markets. During your deal underwriting, assume you will only get 75% LTV in a tier 1 market. Many investors make this mistake.

Here’s a common scenario: Investor buys a multifamily building for $600,000. They use bridge financing to acquire the building. This private lender will fund 80% (loan amount of $480,000) of the purchase price on a 24 month term. Management then goes awry and the building business plan timeline changes dramatically. That 24 month term is now coming up real quick. The building debt services, but the building is in a tier 2 market and long term debt is readily available at 75% LTV. However, that is not enough to pay off the bridge lender.

The investor now has to pay an extension fee of .25% ($12,000) to the bridge lender for an additional 6 months on the current note. During this time, the investor finally finds a long term lender willing to refinance at 80%. This lender grants them the 80% LTV at a 6.25% rate with 1 point origination. This investor assumed he would be getting a 5.00% interest rate. The building DCR now changes from what they anticipated during their original purchase underwriting.

Hopefully, this scenario paints a very good picture as to what can potentially happen if you overlook the details.

Now, you will also see LTV caps on markets (county populations) that are below 250,000. You may get the terms like an 80% LTV loan, but be capped at 70% because the lender has the location as a risk. This leads me into the topic of MSA’s.

What is an MSA and Why Do Lenders Care?

Commercial real-estate is all about occupancy and how the owner of a particular property will service the debt. Is it an owner-user office condo? Great, how long has the business been operating and what was the past 5 years in revenue? In short, the lender needs to see what cashflow is coming in that will in turn, pay them every month (owners business revenue or from tenant lease etc.).

Lenders are very quick to turn deals down in MSA’s they are not comfortable with. Many investors who are new to the commercial game think this is played like residential. In residential, many conventional lenders will go up to 80% LTV in low populated areas. In commercial, this doesn’t fly because it’s never the investors personal income that is paying the lender. As mentioned before, it is either the investors business or they have tenants that are paying rent to service the debt.

In short, if the county has a smaller population, statistically, there are less people to rent out your building and pay you rent. Many lenders make pricing and leverage adjustments based on the location of the asset. This is extremely important to keep in mind.

Building Condition

Certain investors target value-add deals. For the purpose of this paragraph, I am assuming value add means putting $100,000 or more in repairs to a building due to the physical condition. Some may see value-add as below market rents, bad management, no other income streams in place (laundry, amenity access etc.).

If the building condition is rough, an investor will find themself in the private money realm. Most likely in the 7-12% rate range with a 24 month term. These lenders are familiar with these strategies and generally have construction holdback funds as well. They can also build in an interest reserve, so no monthly payments have to be made for a duration of time (6 months , 12 months etc.). They do this if the building is severely under occupied and does not service debt immediately upon closing. This interest reserve is built into the loan payoff upon refinancing into long term debt.

On the flip side, if the building qualifies for long term debt, but still needs modest work, the lender may still fund the loan, but adjust the pricing or make certain repairs mandatory upon closing. This is not uncommon.

Building Debt Coverage Ratio (DCR)

In commercial real estate, lenders want to see the building pay for itself. That is one of the first criteria the lender will screen for. They want to see rent roll and two years worth of operating history, complete with NOI.

Many lenders use their own numbers to forecast expenses. If a seller puts a 35% expense to revenue ratio, the lender will look at it and probably say, “based on the deals we’ve done in this market, it will be closer to 45%." They will use those numbers for their underwriting. They are well aware of the shenanigans that sellers and brokers put in their marketing packages (IE overstate revenue and understate expenses).

It is in the investor's best interest to underwrite a deal more conservatively, so that when presenting a deal for financing, they have a more accurate picture of the deal than what information was handed to them.

The most common DCR ratio required is 1.25x (the NOI). You can think of this ratio as follows: The buildings NOI must cover the debt by 125%. If the ratio of 1.25 is not met, the building does not pay for itself adequately enough, so that there is no cushion to hedge against the inherent risks of owning and running this building.

Bridge Loans Vs. Long Term Debt

Bridge loans are great for fast acquisitions of value add deals that require an investor to put time into the building to get its performance to where it needs to be to obtain cheaper long term financing that they can put in place for the duration of owning the asset.

As mentioned before, bridge products and long term products will have significant pricing adjustments. Bridge products are inherently more risky because that lender is lending on a non-peak performing asset, or in some cases, severely underperforming / dilapidated structures.

It is always advised for clients taking on bridge financing to take the first deal that works and close the transaction. Do not shop too long for bridge financing, it’s more important to do the deal. I’ve seen many investors lose out on deals because they shopped too hard and too long for bridge financing. Bridge financing isn’t about the pricing, it’s about the lenders execution, communication, and effectiveness to close the transaction.

Once the building is where it’s meant to be, shopping for long term debt is the way to go. Make sure you are comfortable with the rate/terms and other facets of the deal the lender is presenting. This is the loan that will be in place for the remaining 95% of the investors ownership.

Loans Above $1mm

This is the category that everyone likes to talk about. These are the commercial Fannie/Freddie loan products that are some of the most attractive in the entire marketplace. These rates are tied to financial indexes and have added lender margins.

However, these are some of the products on the market because of the non-recourse guarantee and leverage going up to 80%. 80% leverage in a tier 1 market for an agency loan is very common. In addition, Fannie / Freddie also offer programs that are interesting only with the ability to roll into a fully amortized loan, for near stabilized properties, value-add deals (for specific strategies), and incentives for green certified buildings and much much more.

This post is in no way an end all be all guide to Freddie and Fannie commercial financing, but I’ve mentioned the most important points about the products for the scope of this post.

CONCLUSION

To summarize, commercial financing is complex and requires a great deal of awareness and analysis in order to assess a scenario efficiently and accurately. I hope this information that I set forth helps you look at commercial investments in a different light and leads to investors taking a more reliable and reality-driven approach to analyzing deals and new opportunities.

All of the factors mentioned above, all play a role in the deal and why an opportunity may or may not be a real deal. I always advise anyone who wants to get into the commercial game to make sure you tread conservatively and to make sure you have a great team in place that has your back.

Explain your confident stance in the comments. I would love to hear your thoughts, opinions, critiques, and suggestions for future content.