CLIENT EDUCATION Commercial Mortgage Types
Commercial real estate loans are primarily classified by either their stage or their asset class. The stage refers to the financing need of the property and usually falls into one of the following buckets: acquisition, refinance, construction, bridge, or rescue. However, much is just semantics as you can have a bridge acquisition for example. But usually, an acquisition or refinance is assumed to involve a stabilized property unless further indicated. Each stage has different risks and considerations a lender needs to consider in reviewing the commercial loan request to determine how they might feel comfortable structuring the loan, and what loan terms they are able to offer given the risk of the stage.
Lenders also classify commercial loans by property type. Most lenders usually have a specialty or preference for certain sub-types of commercial properties and will modify their underwriting and available loan terms based on that property type. The desirability of certain property types for a commercial lender are both internal and external. External factors would include property location, economic and market factors, and demand for that property type. Internal factors might include the allocation need or lack thereof for that property type in a lender’s portfolio, historical performance and default risk of that subtype within their portfolio, and even personal experience or bias from the decision makers within a particular lending institution.
By Loan Stage:
This is the most common stage an investor might be seeking new financing. At this stage, an investor is purchasing a stabilized commercial property and needs to supplement their down payment with a commercial mortgage. Down payment equity typically coming from the investor(s) with cash or 1031 exchange proceeds from the sale of another commercial property.
Refinances are also a common stage to request commercial financing. This can include “rate and term” refinances which usually take advantage of current market conditions to improve their interest rate, re-amortize the loan payment schedule or structure a more flexible loan to better fit their goals. This can also include “cash out” refinances which tap into the property’s equity to provide proceeds to the borrower for investment or personal use.
Construction loans are used for commercial development projects to provide investors with funds in order to complete a commercial property project. Funds are distributed to the developer in draw phases in order to mitigate risk to the lender. The developer and lender will have a close relationship as they stay in frequent contact during the course of the project. There is a more in-depth scrutiny in evaluating these projects and financing due to the inherent risk of the project failing and not having a completed and stabilized piece of collateral.
This is a niche type of lending usually provided by debt fund and private lender sources. Bridge loans do exactly as they entail, they bridge the financing gap between a commercial property’s current situation and the end result. This may include a vacant building that needs financing until lease-up, or a distressed property in need of funds to complete a rehab stage or repositioning. Quality deals that just require a “quick close” also fall under this category. Bridge loans are utilized on requests that cannot qualify just yet with institutional quality lenders but are still partially stabilized and have less risk than our next stage described.
Rescue financing is also commonly referred to as “hard money” financing. While bridge financing involves having an investor with a solid plan for the project and exit strategy for the take-out loan, rescue financing may not be as clean cut. This stage is for properties that are heavily distressed, have loan qualification issues and perhaps not a clear-cut path to institutional financing. Due to the high risk, these loans are typically only financed by private lenders that require additional equity and higher interest rates in order to justify the risk.
By Property Type:
Multifamily buildings are the most common commercial property type. It’s important to recognize that multifamily is considered commercial only when there are five (5) or more units. Anything (1-4) units for lending purposes is considered residential and would be handled by a residential loan source. Besides traditional multifamily complexes, multiple units on different parcels can qualify for commercial multifamily financing, as long as there are above (5) units total and those parcels are adjacent and adjoining. Condominium buildings with an investor owning (5+) units on various floors would not qualify, neither would (5+) single family residences bundled together but in different neighborhoods of a city.
Office buildings are usually categorized as urban (skyscrapers and high-rise buildings in major metropolitan areas) or suburban which include low and mid-rise buildings usually more spread out or in an office park setting. Office buildings are also classified as Class A, B or C - the higher being more desirable to both tenants and lenders. They can also be categorized by lenders based on tenancy, for example: traditional office, co-working, creative office, flex space or medical office. Tenancy and lease structure can be an important consideration for a lender as demand and outlook for certain industries and office space can affect the occupancy of a property, and thus the income and ability of the borrower to repay.
Industrial properties can be categorized into manufacturing, storage and distribution, and then flex industrial which usually has a higher office component than the other two compared to the warehouse. These properties can have multiple tenants, or be leased to a single tenant both third party or owner-user for a business. Industrial properties are recently in higher demand with lenders given the e-commerce shift our economy has been experiencing over recent years. Industrial properties however also carry more environmental risk for lenders, and loan qualification more heavily focused on the tenant’s income sheet financials if the entire building is leased by a single user.
The term owner-user as a property type is very flexible. It is usually coined as “owner-user” because it signals the loan qualification will be based on the company financials of a business owner, as opposed to an investment property’s Net Operating Income (NOI). Lenders usually have a different division or program to handle these requests different from investment properties. As such, the owner-user property type can be industrial (such as a manufacturer), office (such as a law firm), retail (such as a Mediterranean restaurant) or a business owner operating a self-storage facility property.
Retail properties are properties where you shop, dine and experience. These include malls, strip centers, neighborhood centers, outlet malls and free-standing retail buildings. Retail is usually multi-tenanted, and many times anchored by a large tenant such as a grocery store or a pharmacy. With the COVID impacts on small business and the economy, retail properties now undergo tremendous scrutiny and conservative underwriting as many have had vacancy driven up and lease rates decline, putting the landlord in a more difficult position to repay their commercial mortgage.
NNN (Triple Net) properties are a special sub-type of retail property, although sometimes can be considered industrial. NNN refers to the lease structure of a single-tenant property, with the landlord being expense responsible “net of taxes, insurance and maintenance”. The tenant handles all expenses and passes through a simple agreed rent amount to the landlord, making the investment property very “hands-off” and attractive to novice investors who are not experienced in commercial or don’t desire to be heavily involved in the management. Because repayment relies solely on the income of that single tenant, lenders will scrutinize the tenant’s credit rating (if available), financials, lease and competitors in the market.
Mobile Home Parks
Mobile home parks are organized plots of land that have built a tenancy of detached mobile homes. Most of the time the actual mobile home or coach will be owned by the tenant, while the investor owns the land and rents the space to the tenant to occupy with that mobile home. Mobile home parks can have high profitability given the low expense ratio for owners which translates into good loan qualification based on calculations but can often run into hurdles with lenders based on location, quality of the park, the aspect of transiency of tenants and occupancy being less predictable, or the overall stigma surrounding quality of tenants which can be a concern for many reasons to a lender.
Self-storage facilities lease space to individuals for storage of excess inventory or personal belongings. These leased spaces are known as units with renters having full-time access and owners managing the leasing of those units. Mini-storage is interesting because it is the only property type that can be financed as both an investment property or an owner-user property, since self-storage investors both own the property and manage the operations. This property type is attractive to lenders due to high diversification and easy turnover coupled with high demand right now for storage space. The management experience and historical occupancy of the property is usually under the microscope the most with lenders.
This property type category predominantly refers to hotels and motels, but can also include golf courses, event centers, water parks and amusement facilities. These are usually “owner-user” as opposed to an investment property since it is so specialized, with the property owner also owning the business. Due to COVID impacts, financing for hospitality is primarily from very specialized lending sources that are heavily involved with and understand the hospitality industry and carry very conservative underwriting standards and loan conditions. The historical performance of the hotel, financial strength of the operator and loan guarantor, and rating of the “flag” (i.e., Marriott, Hilton) or lack thereof are most important to potential lenders.
This category is essentially a catch-all for any other remaining commercial property type. This can include churches, car washes, museums, bowling alleys, gas stations and wineries to name a few. The important component of a special purpose property is that it is intended for a single limited use and cannot be converted to a different use without a very large capital investment. This particular and limited use does not make the property very liquid or marketable to a large investor base should the lender need to foreclose. For this reason, only agency lenders or private money lenders typically can finance the special purpose products.
Raw land is exactly what it sounds like. It is the uncollateralized, underlying dirt of a property. Most commonly, raw land is either purchased for business storage (perhaps agricultural equipment, distribution vehicles, etc.) or as land for a pending development project of any commercial sub-type. Because there is no structural collateral or income value as there would be with a multifamily property or leased NNN property for example, the lender is left with an extremely illiquid asset upon foreclosure. For this reason, raw land is the most difficult and most expense to an investor to finance.