Real estate finance can be confusing, since there are many options available to homebuyers when securing real estate finance.
The Internet is chocker-bloc full of real estate finance offers and advertisements and savvy homebuyers should exercise caution when reading such posts. A lack of understanding of real estate finance and how it works continues to hinder the majority of new investors in today’s market simply because they are not aware of the different real estate finance avenues.
While residential mortgages are typically made to individual borrowers, commercial real estate loans are often made to business entities (e.g., corporations, developers, partnerships, funds, and trusts). These entities are often formed for the specific purpose of owning commercial real estate.
An entity may not have a financial track record or any credit history, in which case the lender may require the principals or owners of the entity to guarantee the loan. This provides the lender with an individual (or group of individuals) with a credit history and/or financial track record – and from whom they can recover in the event of loan default. If this type of guaranty is not required by the lender, and the property is the only means of recovery in the event of loan default, the loan is called a non-recourse loan, meaning that the lender has no recourse against anyone or anything other than the property.
Commercial real estate (CRE) is income-producing real estate that is used solely for business purposes, such as retail centers, office complexes, hotels, and apartments. Financing – including the acquisition, development, and construction of these properties – is typically accomplished through commercial real estate loans: mortgage loans secured by liens on commercial, rather than residential, property.
Just as with residential loans, banks and independent lenders are actively involved in making real estate finance available on commercial real estate. Also, insurance companies, pension funds, private investors and other capital sources, including the U.S. Small Business Administration’s 504 Loan program, make loans for commercial real estate.
Another way that commercial and residential loans differ is in the loan-to-value ratio (LTV): a figure that measures the value of a loan against the value of the property. A lender calculates LTV by dividing the amount of the loan by the lesser of the property’s appraised value or purchase price.
When it comes to real estate finance borrowers with lower LTVs will qualify for more favorable financing rates than those with higher LTVs. The reason: They have more equity (or stake) in the property, which equals less risk in the eyes of the lender.
Commercial lenders also look at the debt-service coverage ratio (DSCR), which compares a property’s annual net operating income (NOI) to its annual mortgage debt service (including principal and interest), measuring the property’s ability to service its debt. It is calculated by dividing the NOI by the annual debt service.
Interest rates on commercial loans are generally higher than on residential loans. Also, commercial real estate loans usually involve fees that add to the overall cost of the loan, including appraisal, legal, loan application, loan origination and/or survey fees. Some costs must be paid up front before the loan is approved (or rejected), while others apply annually.
With commercial real estate, it is usually an investor (often a business entity) that purchases the property, leases out space and collects rent from the businesses that operate within the property. The investment is intended to be an income-producing property.
When evaluating commercial real estate finance, lenders consider the loan’s collateral; the creditworthiness of the entity (or principals / owners), including three to five years of financial statements and income tax returns; and financial ratios, such as the loan-to-value ratio and the debt-service coverage ratio.
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