Growing your property portfolio is possible, but you’ll need to make some key calculations.
What’s the biggest challenge for US commercial property investors today? If you listen to the International Monetary Fund (IMF), then it’s finding the right financing options.
Commercial building financing remains the biggest obstacle to CRE entrepreneurs thanks to:
If you’re a CRE investor, then you’re going to need to know how to tackle these issues to grow your property portfolio. Indeed, getting access to the best type of funding is one of the proven commercial real estate strategies.
If you don’t, then you risk falling behind in a CRE industry with much investment potential thanks to multifamily, retail, and industrial spaces still performing well, according to JP Morgan.
So how can you capitalize on this positive outlook and find the right type of commercial building financing to power your next investment?
Continue reading to find out the information you need to work out how to finance a commercial building, including calculating how much funding you need for different types of CRE buildings.
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A common question among investors is “How long can you finance a commercial building?”
Commercial real estate financing terms vary depending on the loan type.
Generally, commercial property loan lengths fall between five and 20 years, with amortization periods (the time to fully repay the loan) often exceeding the loan term itself.
Owner-occupied properties and SBA 504 loans may have shorter terms (one to three years), while CMBS loans can reach 6 years or more.
These are just typical ranges, however. For more specific loan terms, a lender can advise you on the exact length of the repayment period.
You can also look at certain commercial building financing formulas to help create a better picture for yourself.
To make sound investment property decisions you must understand the financing (and refinancing) costs involved in each deal.
Top real estate investors use investment calculators and formulas to get a clear picture of these and find out exactly what type of financing they need.
Johan Hajji, co-founder and co-CEO of property management firm UpperKey, sums it up: “(A comprehensive financial analysis involves) factoring in various scenarios, such as changes in interest and occupancy rates and operating expenses, to understand the investment's risk-return profile”.
Let’s run through the most useful formulas that you can use to do this and emulate the top investors.
The most common formula in real estate, but just to recap: the LTV ratio gives us the loan amount relative to the property's appraised value. This simple figure significantly impacts interest rates, with lower LTVs securing more competitive rates.
Formula: LTV = Loan Amount / Property Value
The Cap Rate is a common feature in any CRE discussion because it’s the best way to estimate the income-producing potential of a property.
Put simply, it estimates a property's annual return based on its net operating income (NOI). This is not a financing cost per se, but it heavily influences the loan amount a lender is willing to offer.
Formula: Cap Rate = NOI / Property Value
Debt Yield is a measure used in commercial real estate finance to assess the risk associated with a loan.
Formula: Debt Yield = NOI/ Loan Amount
The DSCR measures a property's ability to generate enough cash flow to cover its annual debt obligations, including principal and interest payments.
A strong DSCR assures commercial lenders of repayment security, potentially leading to lower interest rates.
Formula: DSCR = (NOI + Depreciation) / Annual Debt Payment
This ratio, primarily used for construction loans, compares the loan amount to the total project cost, including construction and land acquisition.
Formula: LTC = Loan Amount / (Construction Cost + Land Cost)
Calculating formulas will help you go some of the way to finding the right finance for commercial property, but to quickly finance a project you must also take into account several factors according to each property type.
Here’s a look at three of the most common commercial property classes.
The office building sector continues its recovery after just returning to mid-2022 demand levels, according to research firm JLL.
Source: JLL
To capitalize, investors should bear in mind several office space characteristics when it comes to financing them.
The first is that offices generally enjoy lower interest rates due to their consistent cash flow from long-term leases with corporate tenants. However, still-high vacancy rates and tenant creditworthiness may also impact financing terms. Lenders prefer strong anchor tenants with a history of on-time monthly payments.
Second, the DSCR ratio (outlined above) plays a big role here. A high DSCR, indicating ample cash flow to cover debt obligations, reassures lenders and can mean lower rates.
Finally, location matters. Prime locations in major cities with low vacancy rates will command better financing terms than suburban office parks.
Traditional lenders (i.e. banks and mortgage companies) will look favorably on a high DSCR as evidence of healthy cash flow. These will offer the longer terms that office spaces require but rejection rates are still high among these institutions.
The SBA (Small Business Administration), too, has stringent qualifying criteria even if they typically ask for a lower down payment.
The high demands of these commercial loans have led investors to ask themselves questions like “What are alternative ways to finance an office purchase?” and “Should I buy office property with an LLC?” as buyers get more inventive.
The best type of commercial lending for offices is one that can strike a balance between creditworthiness and flexibility, and also be suitable for the long term.
Warehouses, especially those in high-demand logistics hubs, benefit from competitive interest rates due to their long-term leases with established companies. However, lenders are wary of vacancy risks associated with a single tenant occupying a large space.
The LTV (Loan-to-Value Ratio) is also critical for warehouses. Lenders may offer higher LTVs for well-maintained facilities in strategic locations with strong tenant covenants (agreements outlining tenant responsibilities).
An important question to ask here is “How much does it cost to build a warehouse?” or you may need to increase its size.
Warehouses cater to the chaotic nature of the logistics industry so they often require expansion or renovating as they adapt to different challenges.
On top of steady long-term financing, like a commercial mortgage, you may need to consider a business line of credit so that you have ready access to renovation funds at short notice.
Studio spaces, including artist studios, music studios, or co-working spaces, are a niche market. Lenders might require stricter underwriting standards due to potentially shorter lease terms and a wider variety of tenant eligibility.
The Cap Rate (Capitalization Rate) is often crucial for studios as they tend to have lower and less predictable income streams compared to traditional office buildings. A lower Cap Rate suggests a higher-risk investment for lenders and could lead to higher interest rates.
If you’re investing in a studio space, it’s a good idea to highlight its unique value proposition and stable tenant base to lenders to build their confidence and secure more favorable financing terms.
SBA 7(a) loan programs provide more flexibility for securing financing in this niche market. They can be a good option for smaller studio spaces with a mix of tenant profiles, however again they might be hard to get.
If you own multiple studio spaces, portfolio loans allow you to finance them under one umbrella, potentially simplifying the process.
Where traditional loan options are unavailable, bridge loans or alternative lending can help you out, but these come with higher interest rates and short terms.
Investing in multifamily properties (a residential building with multiple housing units) requires a nuanced lending approach.
First, we need to look at the property class. Prime locations with high occupancy (Class A) get better terms and LTVs than those in Class B or C.
Lenders also favor well-maintained buildings with consistent upkeep. Extensive renovations or deferred maintenance can sometimes limit commercial building financing options.
A strong DSCR showing sufficient cash flow to cover debt is crucial. Stable rental income also strengthens your application.
Finally, high and consistent occupancy rates are essential – lenders see vacancies as lost income and potential deferrals.
Long-term business loans from traditional lenders and the government (including FHA and SBA loans) are great options if borrowers can qualify for them.
Investors often fall down, however, when it comes to soft deposits, also known as earnest money deposits, a common feature of multifamily investments.
This can often cause a deal to fall through due to the buyer not being able to provide a down payment to confirm their interest.
Some online earnest money lenders, though, are stepping up to meet this demand with a fast supply of funds (often within 48 hours), high acceptance rates, and affordable pricing.
Commercial real estate investors and business owners know how important time is in the fast-paced world of real estate.
If you’re one of them, you may have even lost out on an amazing investment due to slow commercial building financing which meant you couldn’t raise a soft deposit in time to secure a deal.
At Duckfund, we were alarmed at how often this happened to CRE buyers, so we launched our Sign Now Pay Later Model.
Here's how we cut the waiting game and get you to the closing table faster:
With Duckfund's Sign Now, Pay Later model, you can act fast and secure the best CRE opportunities before they disappear.
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