Commercial Real Estate Financing
Finances play a major role in commercial real estate. It doesn’t matter how good the bargain is if you can’t afford it. As a result, prospective investors should become acquainted with the many possibilities accessible. Short-term financing alternatives, in particular, should be thoroughly understood by investors since they allow great flexibility in completing a transaction before acquiring a permanent mortgage. So, in this post, we’ll provide you with a general review of short-term financing for commercial real estate.
We’ll go through the following subjects in detail:
- The Importance of Short-Term Financing in Commercial Real Estate
- Acquisition Loans
- Building Loans
- Bridge Finance
- Last Thoughts
Why Does Commercial Real Estate Need Short-Term Financing?
Commercial Real Estate Permanent Financing
The phrase “permanent financing” in commercial real estate describes a lengthy mortgage with amortization. In contrast to business finance, where loan terms and amortization are frequently aligned, residential real estate generally does not. Permanent finance is sometimes associated with a loan term that is shorter than the amortization duration. For instance, a developer could be able to acquire a mortgage with a 10-year term and a 25-year amortization, but this mortgage would need to be refinanced or necessitate a balloon payment after 10 years.
Typically, developers can only obtain this kind of long-term financing if a property has reached a stable condition. Depending on the specific lender, this often implies that developers of multifamily properties lease 90 to 95% of the units. This presents a funding dilemma for these developers: how can we fund the purchase, development, and lease-up of an asset before it is eligible for long-term financing?
The Importance of Short-Term Financing
Short-term finance comes into play. This broad word encompasses all forms of debt finance other than permanent funding. These short-term alternatives, in general, give developers the ability to finance a portion of the life cycle of development before acquiring a permanent mortgage. Or, as the name implies, they offer quick fixes to enable a certain kind of capital investment.
A range of short-term funding solutions is available to developers, depending on their specific requirements. However, each of these alternatives has certain common characteristics:
Non-amortizing: In contrast to long-term loans, short-term financing frequently does not amortize. In other words, you don’t consistently pay principal and interest. Instead, these loans often include interest-only or accrual installments with a final lump amount repayment at maturity.
Less time commitment: As the name implies, these financing choices have far shorter commitment times than long-term loans. The majority of short-term fixes have periods of 3 months to 3 years, with 1-2 years being the most typical.
Higher interest rates: Because of the loans’ shorter periods, they sometimes have interest rates that are higher than those of permanent mortgages. However, market circumstances, a borrower’s profile, the particular loan type, and the loan’s intended use will all affect the real rates.
In the following sections, we’ll provide concise explanations of various common short-term funding options. This article will not make you become an expert. Instead, we’d like to introduce you to potential options that you may use in a future transaction.
Acquisition Loans
Loans for quick acquisitions are used by real estate developers to buy properties. Lenders often offer a lump sum payment as a consequence, which the developer will later repay during the refinancing into permanent financing. For two reasons, temporary loans are typically utilized instead of a permanent mortgage.
The first step before stabilization is often some sort of building or maintenance on commercial structures. Lenders won’t authorize long-term mortgages as a result until that job is finished. Developers that use acquisition loans can buy a property, carry out the required repairs, and then convert the temporary loan into a long-term mortgage. Additionally, depending on the particular agreement, developers could pay for those repairs out of their own pockets or by combining an acquisition loan with a construction loan (discussed in the next section).
Loans for acquisitions, on the other hand, let investors capture possibilities rapidly. There can be a fierce rivalry for particular properties in the world of commercial real estate. An acquisition loan for a short period may typically be closed by developers far faster than a permanent mortgage. In competitive marketplaces, this speedy turnaround enables much faster contract closings.
Loans for Construction
The following building projects are funded by these loans for the developers. Since this is the case, financial institutions typically offer loan-to-cost (LTC) loans for building projects. Imagine that a $2,000,000 project has attracted competing bids from developers. If the entire cost was $2,000,000 and the LTC was 80%, the lender would finance $1,600,000 for construction ($2,000,000 total price x 80% LTC), and the developer would contribute the remaining $400,000 in financing.
However, lenders face a risk when lending money against projects that need to be built. Consequently, these loans are based on overall charges by the lenders. The underlying collateral (i.e., the properties) would not be sufficient to satisfy the existing loan total if a developer got a cash payment and then defaulted before starting any work.
Because of this, lenders only provide building loans in draws. Instead of making a single payment, lenders approve draw requests when developers have completed a predetermined amount of work and a particular proportion of it. Continuing with the previous scenario, suppose the developer finishes $200,000 in work. They will then file a draw request for the $200,000, together with the related certification of work accomplished, and receive those monies. They would have had $200,000 pulled on a construction loan for $1,600,000 at that point, with $1,400,000 still available for loan draws. It should be noted that only the money already borrowed is subject to interest payments—not the whole loan balance.
Lenders to the construction industry defend themselves against default in this way. A project can never receive a loan for more than the expenditures involved.
Bridge Loans
The term “bridge loans” refers to a broad category of financing rather than a specific form. These loans are especially made to “bridge” the space between an urgent need for money and a longer-term funding solution. For example, a developer of historic tax credits will not receive investor funds from the tax breaks until the facility has been stabilized and a cost audit was already completed. Numerous tax credit developers take out bridging loans to obtain this money sooner in anticipation of the impending financial investment. With the funds they get from the investment, developers use the bridge loan’s outstanding balance to pay down the developers’ debt.
There are trade-offs with bridge loans, much like with hard money loans in residential real estate investing. The fact that they may close very rapidly makes it possible for investors to benefit from agreements. Bridge loans are frequently granted only based on the asset itself—not the revenue it produces—rather than through a thorough underwriting procedure.
However, the interest rates are greater with this speed. Bridge lenders provide higher rates compared to commercial loans with similar parameters to account for the greater lending risk (e.g. a fully underwritten acquisition loan). Investors must thus take into account these increased rates when evaluating potential deals.
Last Thoughts
We did not intend for you to become an expert in various funding choices, as was previously indicated, in this text. Instead, we want to show developers and investors a choice of alternatives to satisfy their short-term funding needs.
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