Commercial Real Estate Notes Get The Job Done
What Is A Commercial Note?
Commercial notes for our purposes refer to promissory notes secured by commercial real estate.
Seller financing is the basis for creating real estate notes purchased by the cash flow industry, so it’s important for us to consider how institutional financing compares to seller financing of commercial property.
This article will cover the similarities and the differences between residential real estate notes and commercial real estate notes. I will also review the potential benefits of selling a commercial note in whole or part.
Questions To Ask When Obtaining A Commercial Mortgage
Whether you are buying a commercial property, or you are the seller, the actual buyer will typically consider a mortgage from a bank or another commercial lender. This is an obvious alternative to seller financing. Here are some key questions to ask yourself or the lender:
How am I going to meet the loan repayment terms?
How much should I borrow? What’s the maximum amount I should consider?
Depending on the amount I target, what interest rate will allow me to meet the repayment terms? Would a higher interest rate allow me to borrow more?
How long will it take to get a commercial loan? It could take weeks to get a commitment. Afterwards the credit committee may still decline the loan.
What kind of covenants and conditions will be required as part of the loan documents?
What type of financial reporting will be required? Are you prepared to meet the level of documentation required by the lender?
What concerns might there be if I want to sell the property? Will the mortgage have a due-on-sale clause or a prepayment penalty? Is the loan assumable?
What are the total costs of the mortgage? According to StackSource[2] these are the typical closing costs of a commercial mortgage:
Lender’s processing/underwriting fees — $500-$2500
Credit Checks — $100-$1000
Appraisal — $1000-$10,000
Environmental report (Phase 1) — $2000-$6000
Inspections — $0.03-$0.10 per sqft
Title search/title insurance policy — $2500-$15,000
Mortgage Registration/Recording Tax — varies by location
Lender’s origination points — 0-2%
Commercial mortgage broker’s fee — 0-2%
Lender’s legal fees — ?
Your own legal fees — ?
After paying all closing costs, will I have enough cash reserves to meet lender requirements? The amount needed could range from six to twelve months of mortgage payments.
Is there a balloon payment? While this may be helpful as part of seller financing, a balloon is typically a requirement of commercial bank mortgages. This will force you to apply for more financing. This leads to more closing costs, possibly less favorable loan terms, and the risk of not qualifying for loan renewal with the same lender.
Will I have to maintain minimum assets as reserves or deposits with the lender?
Will the lender allow me to take out a second mortgage at closing or in the future? If the answer is no this limits your flexibility.
Do I want to provide a personal financial statement to the lender?
Do I want to provide three years of tax returns to the lender?
Do I want to provide all the other required information to the lender?
Of course there are other questions that may be helpful to ask. But starting with those above, how much easier might it be to arrange seller financing than meeting bank requirements? In addition, if seller financing is available, what other funds and sources of funds will be needed to complete a property purchase?
While the process may take a substantial effort, especially for your first transaction, commercial real estate notes get the job done. Through some combination of commercial lenders, seller financing, the buyer’s own funds, partners, private lenders and government assistance, commercial properties are purchased.
As you consider the questions above, keep in mind that you will experience various stages as a property owner. These stages may include:
Initial purchase
Refinance when a balloon payment is due
Cash out refinance as equity grows
Property seller
Provider of seller financing
Seller of a seller financed note - whole or partial
What will your game plan be at each stage?
Good News - the Dodd-Frank Act does not apply to commercial real estate!
Benefits Of Seller Financing
If you are interested, you will find more benefits of seller financing in other parts of this website. To offer another viewpoint here are some thoughts from Commercial Real Estate Exchange, Inc. (CREXI)[3]. In an article titled “What Is Owner Financing For Commercial Property?” they state “Seller Benefits Include:”
The ability to sell a problematic property at a reasonable price with a faster closing, and fewer days on the market.
Accruing monthly interest income for the seller as part of each mortgage payment from the buyer.
Paying capital gains tax pro rata with each buyer mortgage payment instead of in one lump sum.
The ability to sell the note to a real estate note buyer.
Option to foreclose and take the property back if the buyer defaults on the owner-financed mortgage.
Of course there are advantages and disadvantages to seller financing from both the buyers and sellers perspective. That’s just part of life and part of business. But seller financing offers the benefits of much flexibility.
With seller financing the buyer already has had contact with the seller regarding the property. And the seller of course knows the property. As a deal comes together to purchase the property, the buyer and seller develop a relationship. Seller financing is then an extension of that process. Buyer and seller negotiate the financing terms and come to a mutual agreement.
Institutional financing brings a third party into the process who often is not familiar with the property. They are also limited by their company’s own criteria for what they can offer.
Ideas For Structuring Your Note
This section takes the perspective of a property seller who will provide seller financing, and may sell the note sooner or later. Of course these ideas are also relevant to property buyers.
Consider that a property seller may only provide seller financing once, or infrequently. A successful note buyer should have much more experience with notes. While the note buyer’s motivation is different than a property seller, the way a note buyer would structure a note that they want to purchase, is an excellent template for the property seller to follow.
That said, a property seller will face a different set of issues than a note buyer. Even if highly motivated to sell the property, a well structured note is important. So the property seller needs to focus on creating a note that allows a buyer to purchase the property, while ideally making the note favorable to a note buyer.
Down Payment
A down payment in the range of 20-30% will put a note for sale in the category to receive the best possible price. In rare cases even zero down may work. Everything else about the note, the payor and the property would have to be great. 10% down is a good minimum to aim for.
Interest Rates
ValuePenguin, a LendingTree company[4], published an article titled Average Commercial Real Estate Loan Rates for 2021. Last updated July 29, 2001, here’s what they say:
“The average interest rate on a commercial real estate loan is about 2.2% to 18%. The actual interest rate you secure depends on the type of loan you choose, your qualifications as a borrower, and the type of building or project you’re financing. To help you compare rates, we reviewed over a dozen types of loans and properties to compile the average interest rates for commercial mortgages.”
By looking at a variety of loan types they have found a substantial range of interest rates. The upper range of interest rates above is based on bridge loans and hard money loans.
For seller financing if you can get a 10% interest rate, that positions you for the best price to sell your note. That also depends on the credit history of the property buyer. The greater the down payment, the more room there may be for a lower interest rate.
A low down payment adds to the conflict in setting a favorable interest rate. And what's favorable for the property seller can be just the opposite for the property buyer. A low down payment warrants a higher interest rate, but leads to a conflict since the amount financed will be greater. So the mortgage payments are higher already because of the low down payment, and a higher interest rate will make the payments even higher.
Amortization
An amortization schedule is used by the lender to provide a loan repayment schedule based on a specific maturity date. Longer schedules reduce the periodic payments.
Payments may include interest only, interest and principal, or principal, interest, taxes and insurance (PITI) common in residential mortgages.
Assuming payments including principal and interest, note buyers will not be concerned about the length of amortization as long as the term is short enough, but not too short to make a timely balloon payment unlikely.
Term
The term of the note refers to the time until the unpaid principal balance must be paid off. For commercial notes the term is often shorter than the amortization schedule. The shorter term is completed by the balloon payment, which refers to the final payment at the end of the loan term. While residential notes most often have a 30 year term, commercial notes commonly have a term ranging from 5 to 15 years.
A seven year term is attractive to note buyers. From the note buyers perspective more money sooner is better. Their concern is how likely it is that the payments will be made on time. The balloon payment is viewed as the greatest challenge for the payor.
Consider your options by reviewing What’s Better, A Balloon Note Or Stepped Payments? These alternatives are available for residential and commercial real estate notes and for business notes as well.
Credit History
For the best price to sell your note, note buyers would like to see the payor having a credit score of 675 or higher. Lower credit scores can be balanced by a substantial down payment. The Debt Service Coverage Ratio covered below dives deeper into the ability to make the periodic payments.
Seasoning
One month or more is preferred. How much seasoning is needed is a debatable point. Some note buyers consider a note green if there is less than 12 months of seasoning. Other note buyers don’t need that much seasoning to offer their best price, if enough other factors are favorable.
Most note buyers are not willing to do simultaneous closings (as defined in the cash flow industry). Even a note buyer willing to do a simultaneous close, will call it that, but require one month of seasoning. Here is more information for you about simultaneous closings.
Debt Service Coverage Ratio (DSCR)
The Debt Service Coverage Ratio measures the ability of the property’s historical Net Operating Income to cover the debt service. The debt service is equal to the total of principal and interest payments on the note, and related payments, if any. The DSCR is an important part of lender analysis for commercial real estate loans.
To calculate DSCR, divide the net operating income by the debt service. Note that some lenders may calculate DSCR in slightly different ways.
A Debt Service Coverage Ratio of 1.2 is viewed as the minimum desired by a note buyer. So if the net operating income is $100,000, the total debt service needs to be $83,333 or less. If the total debt service is $83,333, the net operating income needs to be $100,000 or more.
A higher DSCR is a measure of greater financial strength. Depending on the other factors of the note, the payor and the property, a note buyer could easily be looking for a DSCR greater than 1.2. In a basic sense this metric is being used to assess a payor’s ability to make the mortgage payments.
The Debt Coverage Service Ratio required by banks will vary from one lender to another, by type of asset and macroeconomic conditions. The number required to qualify for bank financing, may also be a requirement to maintain, in order to avoid default.
DSCR requirements for seller financing often have more flexibility than with banks. Nevertheless the DSCR is an important tool. While negotiating the sale of a property, the DSCR should be used to help determine the other factors above used to structure the note. If the interest rate and term seem appropriate, but the DSCR is inadequate, the deal probably won’t work in the long run.
If the DSCR is less than 1.2 it doesn’t mean that the note can’t be sold, or that a decent price can’t be gotten. The same applies to the other note factors being less than ideal. If some factors are strong, that will help mitigate the lesser ones.
If the DSCR is less than 1.0, then cash flow is insufficient to make the debt service payments. How strong are the borrower’s other financial resources? Are they strong enough to back a personal guarantee? Adding additional collateral to the note would make a difference.
Helpful Clauses
Some helpful clauses to consider including in the note are:
Late payment penalty
Prepayment penalty
Assignment of rents
All of the above ideas for structuring a note can be subject to negotiation between buyer and seller. The process of structuring a seller financed note really begins during the negotiations to sell a property. During that process many other considerations will be taken into account. I think it makes sense that the viewpoint of a note buyer be used to achieve a note that works in the long run. Qualified professionals should also be used to incorporate proper tax advice, and to write the actual note.
For commercial real estate note guidelines from the perspective of regulations faced by banks who provide commercial real estate lending, take a look at Commercial Real Estate Note Guidlines - Part1. This article will give you two perspectives:
- The mindset that banks use in structuring notes that you can utilize in structuring your own notes.
- Learning more about bank practices that will help you secure bank financing.
Business Notes
While business notes are a form of commercial notes, in the cash flow industry there is a distinction. A pure business note does not include real estate. When a business is sold, the note includes all the other assets of the business, apart from the real estate.
As the seller of a business that includes property, creating a separate note for the real estate, and another note for the other business assets, gives you more options. This applies both when you are structuring each note, and in how you use those assets in the future.
Part of the guidance here comes from the note buyers’ perspective. Business notes are considered one of the more difficult notes to buy and hold profitably. This is understandable when one considers the challenges in getting bank financing to purchase a small business.
There is a greater pool of note buyers for real estate notes than business notes. Yet business note buyers make that process a niche. So looking ahead when creating notes, give yourself the advantage of doing so in ways that will increase the price you receive, should you ever decide to sell any notes.
I mentioned above that a down payment of 20-30% for real estate notes, positions a note seller for an excellent price if they sell the note. For business notes 20% down is a minimum, and more than 30% is better. Using a separate note to sell your real estate, and a separate note for the business, enables you to structure each note most favorably for the down payment, and each other factor making up your notes.
For more information about business notes take a look at these resources:
Thank you for reading this article. If you ever have a note for sale, please complete one of my worksheets so I can get to work for you.
References
- Photo by Frans Ruiter on Unsplash
- StackSource, "Typical closing costs for a commercial mortgage," by Tim Milazzo, January 31, 2020, Typical Closing Costs For A Commercial Mortgage
- Crexi, "What is Owner Financing for Commercial Property?" by Shanti Ryle, September 28,2022, What Is Owner Financing For Commercial Property
- ValuePenguin, "Average Commercial Real Estate Loan Rates" by Erica Gellerman, February 19, 2021, Average Commecial Real Estate Loan Rates