How to Finance Your First Commercial Real Estate Investment
Are you struggling to finance your first commercial real estate investment?
Do you want to learn how to build wealth and generate passive income through commercial real estate, but the unknowns of the financing side are holding you back?
I’ve financed tens of millions of commercial real estate investments and developments, and in this post I'll guide you through the step-by-step process of successfully financing your first commercial real estate deal and answer the most frequently asked questions we’ve gotten at the end.
So, let’s get ready to take the first step towards building your real estate empire!
Step 1: Assess Your Financial Situation
Assessing your financial situation is a critical first step in financing your first commercial real estate deal. This involves taking a close look at your current financial position, including your credit score, income, expenses, and overall financial stability. The better you understand your financial situation, the easier it will be to determine what financing options are available to you and what terms you can realistically negotiate.
A good credit score will help you qualify for better financing terms and rates, while a poor credit score can limit your financing options and make it more difficult to secure financing. In my experience, it hasn’t been as important of a determining factor as your overall financials or how lucrative the deal is, but it's important to review your credit report and address any errors or issues before applying for financing.
Next, you'll want to take a look at your income and expenses. So, tally up your current income, as well as your monthly expenses and current debt. This will help you determine how much you can realistically afford to invest in commercial real estate and what type of financing you'll need to secure.
Then, you’ll want to dive into your overall financial stability with your assets, liabilities, and cash reserves. Lenders will want to see that you have enough cash on-hand to cover any unexpected expenses, problems with the project, or downturns in the market.
I typically base my numbers off a 25% down-payment.
So, if you have $500,000 in cash, you could likely afford a $2,000,000 property ($500,000 divided by 25% = $2,000,000). That math isn’t always perfect, but it will give you a solid idea of what you can afford.
Just like a lender will, you should also take your experience and expertise in the commercial real estate market into account. If you're new to the market, you may need to work with a commercial real estate broker or partner with experienced investors to secure financing because lenders prefer to lend to borrowers with experience. Even now, I’ll partner with other investors that also have a proven track record of success in commercial real estate, which can allow us to negotiate better financing terms and rates.
Step 2: Identify Your Investment Strategy
At this point, it’s time to decide on the type of property you’d like to buy, the investing strategy that you’ll deploy, and your goals for return on investment.
The different types of commercial real estate you choose to invest in can have a significant impact on your financing options. For example, lenders will look at financing a retail property very differently than they would on a multifamily property. They can all have different interest rates, amortization schedules, down-payment requirements, and lender appetites.
There are also different investment strategies that you could use on any given project, no matter what type of property you’re buying. Stabilized properties are easier to finance because of their certainty, but won’t give off the highest returns. Development, on the other hand, can bring significantly higher returns but are riskier and, therefore, more difficult to find lending.
Finally, you'll want to consider the potential return on investment - how the project will actually make money. Potential for returns will vary property by property, so you'll want to do a detailed financial analysis to determine if the property is a good investment and if it is bankable. Banks will often want to see a 1.20x to 1.25x debt service coverage ratio (that means $1.20 to $1.25 in revenue for every $1.00 in mortgage payments you have) in order to consider financing a project.
Step 3: Explore Your Financing Options
Before you even start searching for your first deal, I highly recommend exploring a few different ways to secure lending on your investment. There are many different options available out there for commercial real estate, each with its own advantages and disadvantages. Here are a few common financing options for you to consider:
Traditional Bank Loans: Conventional mortgages are loans offered by banks and other financial institutions. These loans typically require a down payment of 20% or more, offer 20-25 year amortizations, and fixed interest rates for a period of time. Conventional mortgages are the most common and are likely your best option.
SBA Loans: The Small Business Administration (SBA) offers loans to small businesses, including those looking to buy commercial real estate. SBA loans typically have lower down payment requirements than conventional mortgages and may offer more flexible repayment terms. However, getting approved for an SBA loan can be fairly intense and you will have to owner-occupy the property.
Hard Money Loans: Hard money loans are shorter-term loans that are offered by private lenders. This option is going to have higher interest rates and fees than other types of loans, often charging 11% or more, but they can be a good option for investors who need financing quickly or couldn’t otherwise qualify for a loan. Word of caution here, though - you must have several exit strategies with this option so you don’t find yourself underwater.
Seller Financing: Some property sellers may be willing to carry the mortgage for the buyers (and you could even negotiate for no money down). This option can be a good one if you're having trouble getting approved for a conventional mortgage or if you’d like to get creative with the debt structure. Seller financing may also come with higher interest rates and stricter repayment terms, depending on the seller, but I’ve found it to be a great way to both buy and sell commercial real estate.
It's important that you explore each of these financing options and compare the rates, terms, and requirements of each lender prior to starting your investment search. Your commercial real estate broker, attorney, or CPA can likely point you toward some financing options to help you get started.
Step 4: Prepare Your Lender Pitch
With this being your first purchase as a commercial real estate investor, there are several things you will need to prepare in order to secure financing on a property. Here are a few key items that pretty much any lender will want to review:
Business plan: You should have a solid business plan that outlines your investment strategy, including why the property is a good purchase, how the property will make money (or at least cover your debt if you’re owner-occupying), any plans for updating the space, and your exit strategy.
Financial statements: Lenders will want to review your financials to verify that you have enough cash on-hand to make the investment, cover the debt service, and that you have a history of responsibly managing your finances. I recommend preparing 3 years of tax returns, a personal financial statement, and 6 months of bank statements.
Credit score: Your credit score isn’t as important of a factor in determining your eligibility for financing as it is in residential real estate, but lenders will still take it into consideration. After all, it is a relative determining factor in the risk associated with you as a borrower.
Property information: This piece will likely be provided in your business plan, but lenders will want you to provide detailed information about the property you're interested in purchasing. This would include the location, size, condition, and potential for generating income. I typically pull a tax record report or send the offering memorandum that the seller put together to give the lender an overview.
Due diligence materials: Lenders will conduct their own due diligence on the property before they will consider giving you financing. This may include property inspections, environmental assessments, and other documentation to assess the property's value and potential risks, so any of that documentation that you can provide will help build your case for obtaining that loan.
If you can gather these items in advance, your chances of securing financing on your commercial real estate investment will certainly increase. It's also important as a first time commercial investor that you work with a knowledgeable and experienced lender. One that can guide you through the process and provide valuable insights and advice along the way.
Step 5: Closing Your Deal and Loan Adherence
Once you have secured financing for your first commercial property, it's time to close the loan but your job isn’t quite over. Here are some important things to keep in mind:
Closing the loan: Before closing, make sure you have all the necessary documents in order and that you understand the terms and conditions of the loan. I always recommend having an attorney review the loan agreement with you. Then, confirm the loan amount and interest rate and review any fees or penalties associated with the loan. Mistakes happen in these documents all the time, so get your eyes on them.
Adhering to loan requirements: After closing, it's critical that you understand and adhere to your ongoing loan requirements. On a basic level, that includes making regular loan payments, maintaining the property in good condition, and providing financial updates to the lender. But it could also mean maintaining a minimum debt service coverage ratio, among other items.
Stay in communication with your lender: It's important to maintain a strong relationship with your lender throughout the life of the loan. If you experience any financial difficulties, that relationship will certainly help you overcome any obstacles. And, if you have questions about the loan, don't hesitate to reach out to your lender for assistance. Look at them as a financial partner.
Monitor market conditions: Keep your eye on market conditions and interest rates so that you know you're getting the best possible deal on your loan. If interest rates start to drop, for example, it may be worth exploring refinancing options to save on interest costs. You could also pull equity out through a line of credit if the property value increases significantly.
Plan for loan maturity: Most commercial real estate loans have a maturity date in the 5 to 7 year range, which means the loan must be fully repaid. Make sure you prepared to repay the loan before that date arrives by exploring options for refinancing, selling the property, or paying off the loan with any excess cash.
Check out our list of the top online commercial real estate courses that will help you understand the industry better so you can buy your first property confidently.
FAQs about Financing Commercial Real Estate
How Can I find a lender for my commercial real estate investment?
There are a few different ways for you to find lenders for commercial real estate investments. Utilizing your network is certainly the best, since they will have personal experience with those institutions, but you could also reach out to local banks and credit unions on your own or utilize a commercial mortgage broker.
How much of a down payment do I need for a commercial real estate investment?
The down payment required for a commercial real estate investment can vary widely depending on the property type, location, and lender. I typically recommend that you prepare for a 25% down payment, but you could see as low as 10% if you are owner-occupying the space to as high as 50% if it is a high-risk investment.
What documents do I need to apply for a commercial real estate loan?
Documentation requirements will vary from lender to lender, but generally, you'll need to provide a personal financial statement, up to 3 years of tax returns, and bank statements.
How long does it take to secure financing On a commercial real estate investment?
In my experience, most lenders will take at least 30 days of due diligence, review, and preparation in order to close on a commercial real estate investment. Some, like hard money lenders, may be able to close faster, while others, like the SBA, could take more than 3 months.
What types of loans are available for commercial real estate investments?
Since commercial real estate is such a popular investment vehicle, there are many different types of loans available for these investments, including conventional loans, SBA loans, bridge loans, mezzanine loans, and many more. You’ll definitely want to do your due diligence to understand the pros and cons of each loan type before choosing which direction you’d like to take.
How does my credit score impact my ability to secure financing?
Your credit score is an important factor that lenders consider when evaluating any type of loan. Having a good credit score will certainly improve your chances of securing financing and getting favorable loan terms, but I’ve found it’s not as important overall as your financials and the strength of the property investment.
What happens if I Don’t make my loan payments?
Just like in residential real estate, the lender may foreclose on the property and take possession if you're unable to make your loan payments. Having a strong relationship with your lender may help in a situation like this, but it’s important to have a contingency plan in place in case you have any unexpected financial difficulties.
As a commercial real estate investor, securing financing is a critical component of your journey to building a thriving portfolio. Among the various loan options available, DSCR (Debt Service Coverage Ratio) loans have emerged as a popular choice, particularly for investors seeking to finance investment properties or build a rental portfolio. However, understanding DSCR loan interest rates and how they are calculated is crucial for making informed decisions and maximizing your returns.