Commercial Real Estate Loans: Types and Requirements

A building with five or more apartments, or any office, retail, or industrial space, needs a commercial real estate loan, because the conventional home loans Fannie Mae buys stop at four units. A commercial lender sizes the loan on the building's net operating income (NOI), its rent minus operating expenses, rather than on your paycheck. Freddie Mac's small apartment loan, for example, requires NOI of at least 1.25 times a fully amortizing loan payment, even on interest-only loans, and lends up to 75% to 80% of the property's value. Expect a loan term shorter than the payment schedule (Freddie Mac offers 5 to 15 years on up to 30 years of amortization), a balloon payment of the remaining balance at the end, and prepayment terms that can make an early sale expensive.

For 1 to 4 unit rentals and the loans that fit them, start with tips for getting approved for an investment property mortgage.

Why the fifth unit moves you into commercial lending

Fannie Mae buys or securitizes first mortgages on residential properties of one to four units. A five-unit building falls outside that rule, so the loan has to come from a bank that keeps it, from Fannie Mae's or Freddie Mac's separate multifamily programs (Freddie Mac's small loan starts at 5 units), or from another commercial source.

Crossing that line changes how you qualify:

• What qualifies you. On a 1 to 4 unit conventional loan, your personal debt-to-income ratio drives approval. On a commercial loan, the property's NOI does, and your net worth, cash, and track record serve as support.
• How the property is valued. Appraisers value income property with the income approach, dividing NOI by a capitalization rate (cap rate), the yield buyers in that market accept, and check it against comparable sales. Our guide to cap rates shows how a small change in that rate moves the value.
• What you document. Expect to provide a rent roll (each unit's tenant, rent, and lease dates), a trailing 12-month operating statement, the leases, and each guarantor's personal financial statement.
• Who borrows. Freddie Mac's small loan requires the borrower to be a single-purpose entity, such as an LLC that owns only this property.
• Who guarantees. Agency programs set minimums for the people behind the loan. Freddie Mac expects Conventional Small guarantors to have combined net worth of at least $5 million and liquid assets of at least 10% of the loan amount or one year of loan payments, whichever is greater.

You do not get the federal Loan Estimate form. Truth in Lending rules treat a loan on a rental you do not live in as business credit, at any unit count, so each lender's term sheet is your comparison document.

Where commercial loans come from

Loan-to-value (LTV) is the loan amount divided by the property's value. Freddie Mac allows 80% LTV on terms of 7 years or more, 75% on shorter terms, and 65% to 70% if you want interest-only payments for the full term. Federal bank guidelines cap a bank's own limit on existing commercial and multifamily property at 85% LTV, and a bank's internal limit may be lower. Bank regulators treat 15 to 30 years as the normal amortization range for income property. When the term is shorter, the balance left at the end is a balloon payment you refinance or pay off.

A CMBS loan is a commercial mortgage-backed securities loan: the lender pools it with other loans and sells bonds backed by the pool.

SBA loans are for owner-users, not landlords. SBA rules bar passive businesses owned by developers and landlords that do not actively use the property, and the SBA lists investment in rental real estate as a prohibited use of a 504 loan. Under 13 CFR 120.131, a business buying an existing building with an SBA loan must occupy at least 51% of it and may lease the rest. New construction has stricter limits on how much can be leased.

How lenders size the loan: NOI, DSCR, debt yield, and LTV

When a lender applies all three limits, the lowest result caps the loan amount, subject to further underwriting.

1. Debt service coverage ratio (DSCR): NOI divided by the annual loan payments. At 1.25x, the payments can be no more than 80% of NOI.
2. Debt yield: NOI divided by the loan amount. It ignores the interest rate and amortization, so some lenders use it as a floor when rates or cap rates are low.
3. LTV: the loan divided by the appraised value.

Freddie Mac Conventional Small also requires an assessment of your ability to refinance the balloon balance at maturity, unless DSCR based on fully amortizing payments is at least 1.40x and LTV is 60% or less. An unfavorable result calls for discussion with Freddie Mac's underwriter and does not automatically disqualify the loan.

Lenders build NOI from the trailing 12 months of income and expenses, then adjust it. They may apply a market vacancy rate higher than your actual vacancy and add a management fee and a replacement reserve for roofs and systems even if you self-manage. Freddie Mac's small loan generally assumes at least 10% vacancy for properties of 30 units or fewer, even if the building is full.

Worked example. A 12-unit building priced at $2,300,000 has an underwritten NOI of $150,000, a 6.5% cap rate. The lender quotes 6.5% interest on a 30-year amortization schedule and requires 1.25x DSCR, 75% LTV, and, as an example, a 9% minimum debt yield.

The DSCR test caps the loan at about $1,582,000, or 69% of the price. You would need at least about $718,000 plus closing costs, not the 25% down the LTV limit suggests. At a higher rate, the DSCR limit drops while the LTV limit stays put, so the coverage test is more likely to set your down payment.

Recourse versus non-recourse

A recourse loan lets the lender collect from you personally, through a guarantee, if a foreclosure sale does not cover the debt. Bank loans often carry a personal guarantee from the owners, and the bank verifies the guarantor's cash and other debts.

A non-recourse loan limits the lender to the property. Freddie Mac's small loans are non-recourse, and CMBS loans commonly are, but with carve-outs: the guarantor becomes personally liable for losses caused by acts such as fraud, diverting the property's funds, environmental problems, unapproved liens or transfers, or a voluntary bankruptcy filing. Certain carve-outs make the entire loan full recourse, and the guarantee lists which ones. Read it before you sign.

Prepayment terms: yield maintenance, defeasance, and step-downs

Commercial fixed-rate loans can charge you to pay off early, and the note sets which method applies. The main forms:

• Yield maintenance: a fee, set by a formula in the note, meant to make up the interest the lender loses when you repay early.
• Defeasance: instead of paying off the loan, you switch its collateral from the building to government securities, which then cover the remaining payments. The property is released and you can sell it, but you pay for the securities.
• Step-down: a set percentage of the balance that falls each year, such as 5%, 4%, 3%, 2%, then 1%.

Freddie Mac's standard small loan uses yield maintenance until the loan is securitized, then a 2-year lockout with no prepayment allowed, then defeasance, with no premium in the final 90 days. Step-down and yield maintenance without defeasance cost extra. If you may sell within a few years, price the step-down option or a bank loan with a short penalty period, and ask each lender for a prepayment estimate at your likely sale date.

How to prepare for a commercial loan

1. Gather 12 to 24 months of property financials from the seller: operating statements, a current rent roll, leases, and utility, tax, and insurance bills.
2. Underwrite NOI the way a lender will. Add a management fee and a replacement reserve, and use the higher of market vacancy, the seller's actual vacancy, or the lender's minimum (10% at Freddie Mac for 30 units or fewer).
3. Run the three sizing tests at the rate you are quoted, plus 1 percentage point, so you know your cash needs if rates move before you lock.
4. Get term sheets from at least one bank and one agency lender, and compare rate, term, amortization, recourse, prepayment, reserves, and fees.

If you own several smaller rentals, a bank may lend on them together as a blanket mortgage. If a 1 to 4 unit property does not fit agency rules, portfolio loans from banks that keep their loans work much like a small commercial loan, and DSCR loans use a similar rent-to-payment test.