Buying Commercial Real Estate

So I get asked often many times a week HOW does buying commercial real estate work??

The answer is based on multiple factors for the potential purchaser.

First question you need to ask yourself is ( How much do you have to invest? ) This will determine in commercial real estate what options are open to you. The size of the down payment will determine type and quality of the commercial asset, loan term and LTV, and if you have the ability to purchase yourself or you will need partners.

One of the mistakes I see is buyers see themselves as large with investing in residential and think that carries over in commercial. So for instance in residential your local banker might love you. You have 10 rental houses and for those price levels your liquidity and net worth looks good. Now you want to jump over into the commercial real estate pond. Where buying a 200,000 house might be considered a large purchase in residential in commercial a small purchase might be 2 million. To a local bank a 2 million loan might be huge compared to their 20 million in deposits. For a larger non-bank lender such as a CMBS lender ( commercial mortgage backed security) it is very small as the larger lenders do billions in loans a year. 

So the first thing I do for potential clients is look at where they are at today and where they want to go. I do this firstly by looking at their (personal financial statement).  This shows assets versus liabilities. Lenders generally want liquidity over net worth. What I mean is if you are showing 2,000,000 equity of owned property but only 300,000 liquid cash, stocks, cash value of life insurance policy, IRA, 401k etc. then your liquidity to net worth is out of balance for getting a loan.

Lenders want to see higher on the liquid side. They want to know you have enough reserves to handle what they call a  "liquidity event" with a property. This is usually when an unforeseen  larger expenses pops up with the property that needs a sudden injection of cash to "weather the storm".  If a borrower does not have the liquid cash available or handy within a few days the sustainability of the property could suffer and a downward spiral happens losing income and value. The default event then could trigger a workout situation with the commercial lender or a loss if it forecloses, etc. 

Lenders generally want to see liquidity of 10% of the loan balance or better after down payment. So for example if a 3,000,000 property at 25% down is 750,000. You would need estimated cash reserves of around 225,000 or 10% of the loan balance of 2,250,000.

Regional and local banks tend to offer shorter term loans than non-bank lenders. The reason is in say five years the local bank can't have loans locked at 4% and be paying out savings accounts with inflation at 3%. They would go out of business with those margins. The larger non-bank lenders can offer non-recourse financing but the downside is generally there is a pre-payment penalty attached to the loan. The reason is the mortgage is sold in slices on wall-street to investors who are guarantee a certain return for a certain hold time. The solution is to have the new buyer when you go to sell it assume the loan. If for example you have a 10 year fixed loan with a 30 year amortization with a CMBS lender in the first few years of the loan the prepayment penalty is really large. As the loan approaches maturity the prepayment starts to go down.

One good part to local bank loans is if for example you have a turn around property and do not want a pre-pay penalty and short term debt. In that case a local bank might be a better fit for you versus a non-bank loan that has a big pre-pay attached to it. The larger non-bank lenders tend to like premium areas versus local banks with a branch presence will lend on some properties a CMBS lender would pass up.

Buying commercial real estate and selling it is like taxes. Not everyone's situation is the same which is why it is a process to devise a plan with my clients and then proceed to execute it.

Stay tuned for more random writings expanding on commercial real estate.

All the best,

Joel