The process of getting a commercial real estate loan shares some steps in common with that of getting a residential home loan, such as underwriting, borrower approval, and property appraisal. However, the commercial real estate (CRE) funding process has much more complexity, due to the business aspects of handling a commercial project and the number of parties involved in any lending agreement. CRE funding requires the borrower to provide much more extensive documentation when applying for a loan.
This article focuses on the steps required to secure debt funding; equity funding isn't covered here.
What are the high-level steps?
- Borrower decides on a CRE project for which to seek funding.
- Borrower decides on a lender from whom to seek funding.
- After initial discussion, lender pre-qualifies borrower for certain loan terms.
- Borrower provides documentation packet to lender.
- Lender reviews documentation and requests additional information as needed.
- Appraiser values the project.
- Underwriter assesses the risk of the loan and provides credit approval.
- Lender performs final review and approval of loan terms.
- Lender and borrower negotiate final terms of closing.
- After closing, borrower provides lender with periodic reports on the project.
From start to finish, expect around 45 days or more to reach closing.
1. Borrower defines the CRE project that requires real estate financing.
In the first step of the funding process, the borrower defines the specific CRE project that requires funding. The project could be a new commercial development, a property acquisition, or a refinance of an existing asset. At the very least, the borrower needs to have a specific project in mind in order to determine the size and terms of the loan to seek.
At this time, the borrower should begin their real estate due diligence by clearly defining and documenting the business plan and financials for their CRE project. The more articulate the borrower can be about their project at this point, the better—as this is exactly the information that the lender will scrutinize when considering the borrower as an applicant.
2. Borrower chooses a prospective lender.
The borrower should select a lender that is compatible with their market level. A borrower looking to fund a middle-market $15 million development, for example, should not be seeking funds from an institution that specializes in financing large corporate endowments. In general, borrowers should look for a lender that has the resources to provide a suitable size of loan with a favorable loan rate.
Where can you get a commercial real estate loan? There are a variety of lending sources that will fund a CRE project based on the project scope and outlook, and the financial background of the borrowing parties.
3. After initial discussion, lender pre-qualifies borrower.
Upon meeting, the lender interviews the borrower to learn about the CRE property and the borrower's financial situation and history.
The lender will discuss the various mortgage rates and terms available under current market conditions and consider the loan packages that might be most suited to the borrower's needs. Generally speaking, commercial lenders expect borrowers to provide a 20% to 25% down payment for a mortgage with a maximum loan to value ratio of 75% to 80%. The typical amortization period for a CRE loan is around 25 years.
At this time, the lender might pre-approve the borrower for a certain loan package based on the borrower's credit history, cash flow, and cash reserves. But just as important, if not more so, as the borrower's creditworthiness is the financial potential of the CRE project itself.
Since the property under consideration will be run as a business venture, the lender will want to assess the borrower's ability to hold and increase the value of the asset—not just through routine building maintenance but via the execution of a viable, long-term business plan. The lender will form an initial opinion of the borrower's CRE experience and track record, as well as a general impression of the property or development. Who are the current or future building tenants? What are the market trends in the surrounding area? These are just a few of the questions a lender might ask to arrive at the terms of an informal loan pre-approval.
4. Borrower furnishes the documentation packet (loan application) to lender.
As mentioned earlier, CRE lenders need to consider a complex array of factors in assessing soundness of a loan application. In this step, the borrower formally presents their qualifications to the lender by providing a packet of supporting documentation.
Among other information, this packet might include:
- Background information about the project, such as its location, size, scope, and development strategy.
- Background information about the sponsor or principal borrower. If the borrower has investment partners, the lender will also want to review background and financial data for these investment partners, such as their past experience with CRE projects and whether those projects gained or lost value.
- Financial information about the project. Borrower will likely be required to furnish the rent roll of building tenants, the capex budget, and the pro forma. As a summary of the estimated cash flow and ROI balanced against taxes and expenses, the pro forma is an important document for lenders to examine.
- Market analysis of the neighborhood surrounding the project site.
Considering that the lender likely has a sizable stack of applications to review, the borrower can facilitate this process (and also increase their own likelihood of securing final approval) by taking the time to assemble a clear, well-organized, and comprehensive documentation packet for the lender.
5. Lender reviews documentation.
This step represents the lender's due diligence. Here, the lender reviews the borrower's documentation packet to assess the risk level posed by the borrower and whether the target loan is appropriate in terms of that risk level. Also, the lender considers hypothetical worst-case scenarios: if the project loses value, does the borrower provide a sufficient guarantee such that the lender could still collect on the loan?
The lender will typically have follow-up questions to certain points in the documentation. It's the borrower's responsibility to be as timely and forthcoming as possible when answering these questions.
6. Appraiser values the project.
While the lender reviews the borrower's application, a professional appraiser is also engaged to assess the project and place a current value on it. The borrower wants to see an appraised price that's equal to or higher than their own estimated valuation of the project.
Appraisers use different methods to assess the value of commercial real estate. The cost approach doesn't take future cash flow into account and is rarely used nowadays. The sales comparison approach relies on the market analysis of properties in the project's surrounding area. Finally, the income capitalization method considers the project's current value in relation to its future cash flow and profitability.
7. Underwriter assess the loan risks and grants credit approval.
When performing a maximum loan analysis, an underwriter will typically consider:
- Net operating income (NOI) based on the pro forma data.
- Loan to value ratio (LTV), which is the total loan amount borrowed divided by the value of the property.
- Debt service coverage (DSCR), which is the NOI divided by the annual debt service.
8. Lender performs final loan review.
Taking all the aforementioned information into account, the lending committee completes a final, comprehensive review. If all goes well, the loan is approved.
9. Lender and borrower negotiate final terms of closing.
The timely and successful closing of a commercial loan is contingent upon having all the required reports and contracts—such as environmental and safety reports, a deposit account control agreement (DACA), and more—in place by the target date. Many of these documents require lead time for preparation and the involvement of third parties. Therefore, it's important for lender and borrower to plan ahead for such logistics so that the close of loan occurs smoothly and on time.
10. After loan closing, borrower provides ongoing project reports to lender.
Unlike residential properties which can accrue value simply through the passage of time and reasonable maintenance, commercial properties derive value from the success of their business operations. The owners must take an active role in maintaining the tenancy, cash flow, and profitability of the venture. And lenders have a vested interest in monitoring the health of a project.
If the project is a new development, the lender may want to make onsite inspections to review construction status. At the very least, the borrower should provide the lender with periodic progress reports to ensure confidence in the project's ongoing value and the loan payoff.
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