What Is Real Estate Finance?
Unlike security investments, real estate finance represents substantial purchases of real property. These purchases can range from a couple thousand dollars for a tract of land to millions of dollars for premium office space in a metropolitan city. As a result, most real estate investors do not have the cash to cover a total real estate investment. Therefore, most real property is bought, using leverage.
A real estate investment loan may come from various sources and be set up in a variety of ways. It is important to learn the sources and terms involved in this type of financing if you wish to invest in multiple real estate. Furthermore, investors can increase the yield of their investment through creative financing.
As a result, some successful real estate investors have made sizable buys with only a minimal outlay of cash—in some instances, with nothing down. This popular investment method is known as OPM, and references using other people’s money to fund real estate.
Types of Commercial Real Estate (CRE)
CRE properties are generally represented by the following:
- Office space is listed as Class A, Class B, or Class C real estate. Class A properties are usually upscale buildings that are in easy access to conveniences. Professional real estate management companies normally oversee the maintenance and management of these buildings.
- Class B CRE properties are frequently older structures and necessitate a capital investment. Although they are often well maintained, the properties normally require some small renovations or repairs. Often, these types of properties are desirable choices among investors.
- Class C CRE properties are normally used for redevelopment. Typically poorly situated, the properties usually need some major improvements, and therefore require a large outlay in capital.
- Special Purpose Buildings - These buildings are normally built by the investor. Examples of special purpose buildings include self-storage sites, retail properties, or car washes.
- Retail Buildings - Properties of this type usually are located in urban locales. The buildings can range anywhere form 5,000 square feet to as much as 300,000+ square feet in size.
- Industrial Buildings -These structures are used for warehousing or manufacturing activities.
- Multi-family Buildings -Multi-family buildings are usually represented by condominium units in high-rises, four-plexes, apartments, or smaller buildings that feature from four to 100 units. The lease terms on these buildings are usually shorter in duration than retail sites or office facilities.
How to Invest in Commercial Real Estate?
Investing in commercial real estate involves valuing a property so the loan amount you receive matches the value. Unlike home loans, commercial financing is not backed by a governmental entity.
Therefore, the rates are normally higher. When buying commercial real estate, balloon loans are commonly used, so you must calculate whether your estimated income will support the pay-off for this type of mortgage. If you cannot pay off the loan, you may have to refinance at a higher rate of interest.
Extra charges that are included in the loan price include the application fees, legal fees, and survey fees. Normally, these charges must be paid before the loan application is processed.
How Commercial Loan Underwriting Works?
Understanding the underwriting process for a commercial loan will provide you with a decided advantage when you seek financing for commercial real estate. Before the underwriting process is performed, the borrower and lender review the current rates of interest and the lending institution’s loan policy on underwriting ratios. These ratios include the debt service coverage ratio and the loan to value ratio. Lender adjustments to net operating income (NOI) are also discussed.
Net Operating Income (NOI)
The first phase in the underwriting process is to determine the NOI. A borrower normally submits a pro forma and rent roll to the lender. A pro forma refers to a method by which financial results are determined. This technique emphasizes projected or current figures.
The borrower, as well, will create a pro forma for underwriting purposes, which may result in a different calculation for the NOI. Adjustments may include an increase in the vacancy and credit loss element to cover tenant rollover risk or current market conditions.
Loan to Value Ratio (LTV)
The LTV is the ratio of the financing borrowed in association with the property. Therefore, the LTV is equal to the loan amount divided by the property value. If you purchase real property for $1,000,000 and the appraised value is $1,250,000, the LTV, using this formula, is 80%.
Debt Service Coverage Ratio (DSCR)
The DSCR is the ratio of the net operating income to annual debt services. This ratio is important to a lender as it ensures that a property has the needed cash flow to cover the financing. The DSCR is determined by taking the NOI and dividing it by the annual debt service ratio. Therefore, this calculation provides the lender with a margin of safety. Like the LTV, the DSCR is established by a lending institution’s loan policy. Therefore, it can differ by the type of property. A riskier property will normally come with higher DSCR requirements than a more stable piece of real estate, such as apartment units.
Performing a Maximum Loan Analysis
A maximum loan analysis is used to calculate the optimum supportable financing, based on the requirements for the DSCR, NOI, and LTV. Once the NOI is determined by the lender, he or she will then determine the LTV and DSCR. After making these calculations, he or she takes the lesser of the two financing amounts, based on the DSCR and LTV methods.
Loan Repayment Schedules
Commercial mortgage repayment is set up, using the following structures:
Constant Payment Mortgage (CPM)
The constant payment mortgage of CPM is the most common type of mortgage used for investing in real estate. This type of financing is made up of a level principal and a fixed rate of interest. It is called a CPM loan because the investor pays a fixed payment each month.
Constant Amortization Mortgage (CAM)
This type of mortgage is yet another common type of commercial mortgage. The payment structure for this financing is known as a straight-line repayment method. The borrower pays the same interest each month but the interest varies, depending on the loan balance.
The Graduated Payment Mortgage (GPM)
This type of financing is often used in residential real estate financing. However, the repayment structure can also be used for commercial financing. Lower payments are made earlier in the loan term and gradually increase as time progresses. In a commercial situation, a GPM may be helpful where the leases for real property increase over time.
Adjustable Rate Mortgage (ARM)
An ARM is a variable rate loan that features a fixed spread for a specific time before increasing in the following years of the loan. Rates are typically lower during the early years and increase over the loan’s life.
Zero Amortization Mortgage (ZAM)
This type of financing, also known as an interest only loan, does not lessen the principal on the financing during the financing term. Therefore, this type of loan repayment is often associated with speculative financing. The balance of the loan is not reduced over the loan’s duration as another repayment source is planned.
In some instances, balloon loans may be made to short-term investors who agree to pay off the loan at the end of a five or seven year period in one large amount, or balloon payment.
When investing in commercial real estate in San Diego it's important to have property lawyers like Equity Legal LLP guide you in setting up the proper real estate finance contracts or brokerage