Commercial Real Estate has numerous sources of capital to help finance new and existing CRE projects. Each type of capital source is different from the other not only in name, but in its characteristics and costs/benefits to the client. This article is a short summary of the basic types of capital and the general pros/cons of financing your project from each capital source. This is not an all-inclusive list, and as per the nature of CRE where exceptions are the rule, this should only be taken as general guidelines:
Traditional Financial Institutions
Traditional financial institutions are typically considered banks and credit unions. They can be large (Bank of America, Chase, Wells Fargo, etc) and small (local credit unions, regional banks, specialized business banks, etc). They can have access to balance sheet or “portfolio” lending where they are the true source of capital. More often for the smaller institutions (credit unions in particular) they share the risk of a single loan amongst several other institutions with similar credit guidelines.
The benefit of working through traditional financial institutions is typically costs. They typically do not charge up-front fees outside of an appraisal, and most of the other costs of the transactions are usually absorbed by the bank. They also have the ability to be flexible with regards to asset classes. If a property is within their lending sphere, they can usually provide financing to any type of property, assuming it qualifies. There is more flexibility with prepayment penalties, step down penalties are much more common and in some rare instances a prepayment penalty can be mitigated completely. Lastly, they are typically a full service financial services provider, so there is some limited ability to create more flexible loan options if the bank has large deposits from the client.
On the downside, they become less useful for the larger loan balances and the sophisticated commercial real estate investor. The loans they provide are almost never non-recourse loans. In the underwriting process they underwrite the client as well as the subject property, and many banks/credit unions have onerous guidelines regarding residual income, income concentration, and reserves. Most banks have a limited capacity to fund large transactions. If a loan is shared with other financial institutions, this decreases substantially the chance the loan will be approved as each institution must sign off and it must go through multiple credit committees. In many cases they require a substantial banking relationship.
Commercial Mortgage Backed Securities
CMBS loans account for a large portion of the CRE marketplace for transactions larger than $5MM. These loan transactions are of investment grade quality, and are typically bundled together in tranches of $500MM+ and sold off on secondary markets, oftentimes as a replacement asset for AAA Bonds. There are many investment companies in the marketplace that originate and consolidate these transactions, including many investment banks and larger financial institution / banks.
The benefits of CMBS loans are their flexibility. So long as the underlying asset meets certain financial guidelines, the loan itself can be structured to match the needs of the client. The loans can cross collateralize multiple properties; ownership can be structured between many separate entities; almost all asset classes qualify for CMBS loans, provided the loan amount is adequate; all CMBS loans are non-recourse; the underwriting criteria for the sponsor is limited. All of these factors make CMBS loans attractive to sophisticated commercial real estate investors.
CMBS loans are also generally very liberal in their terms. They are typically 5 and 10 year fixed terms, but with quality properties and low leverage, we can negotiate interest only terms. Additionally, asset classes that generally have shorter amortizations (hospitality and other specific use) can achieve longer amortization terms (25-30 years) with portions of that I/O.
There are two primary negative aspects to CMBS loans. First, there are substantial up-front costs associated with CMBS loans. It is not uncommon to have $25,000 – $40,000 in up front costs/fees, with the largest portion of these going to legal fees. Second, CMBS loans typically have substantial structure involved, meaning it is not uncommon to have a lockbox on the loan, reserves can be required for TI’s and leasing costs to replace major tenants, and if there is deferred maintenance it must be managed at the beginning of the transaction.
Agency lenders are those lenders that represent the two quasi-governmental agencies Fannie Mae and Freddie Mac, as well as those lenders that work directly with HUD (FHA). When working with Agency lenders they only lend on certain asset classes, primarily multi-family properties (with some ability to do mobile home parks and assisted living facilities). The same way that residential lenders work with Fannie/Freddie/HUD, so to do agency lenders work with the multi-family divisions of these governmental agencies.
The pros of going the agency route are many. Depending upon the market, they can be extraordinarily competitive on interest rates, oftentimes leading all other capital sources. There are numerous terms available, from fully adjustable loans to 35 year fixed terms. Loan amounts can go down to as low as $750,000 and they can lend in areas that are not traditionally desirable for other lending sources. These loans are non-recourse loans as well.
The downside to these transactions is that the properties and the borrowers must meet all of the guidelines laid out by the governmental agencies. These regulations are fairly broad and inclusive, but if the project strays outside of these guidelines, even by a little, they will not qualify for loan funding. These are paperwork intensive transactions and tend to take quite a while to actually fund. Average funding time for a Fannie/Freddie loan is 60 days (quite reasonable) but HUD can run 9 months and more.
Insurance companies are very active lending resources in the commercial real estate market. They typically lend their own funds, providing financing for large, high quality projects.
The pros on insurance companies is they have a substantial amount of flexibility in lending. They provide capital using their own funds, so they have more flexibility in structuring transaction as they do not have to sell them off immediately. Their interest rates fluctuate based on the performance of their own portfolio, and at times can be the absolute lowest costs of funds in the marketplace.
Unfortunately, typically insurance companies only like to fund large projects, usually with a minimum loan amount of $10MM. Fees on insurance loans are similar to CMBS loans, higher costs due to the large amount of flexibility provided in vesting and structure. However, because of the size of the transactions this is typically not a substantial limitation.
Written by: Shawn Harris, Sr. Vice President, San Diego Commercial & Business Financing