Commercial real estate is a multitrillion-dollar market in the United States. It’s commonly defined as an improved piece of real estate that’s leased to a third party to provide a return for the investor.
To maximize return on investment, the owner will usually leverage his or her capital by financing the real estate investment with a commercial real estate loan. The types of commercial real estate loans that can meet an investor’s needs vary — according to the property’s condition, useful life, type, lease strength and terms, and the owner’s investment strategy.
Where Should Borrowers Begin?
If you’re looking to purchase commercial real estate to achieve your business goals, your initial evaluation should focus on the net lease payments — the lease minus any costs you might incur as the owner — and the likelihood that the lease revenue will continue in the future.
Many leases are triple net leases, often abbreviated as NNN. This indicates that the tenant is responsible for taxes, insurance, and maintenance. Reading the fine print is important here, as some NNN leases still contain potential maintenance items that might be the owner’s responsibility.
Equally as important as the lease payment is that payments will continue uninterrupted in the future. In the best-case scenario, you have a long-term lease with a strong, nationally known tenant that provides good prospects for reliable future lease payments. These types of tenants often command lower capitalization rates, or cap rates, due to their presumed cash flow safety. (We’ll explore cap rates more in the next section.)
In many cases — such as retail strip malls — the tenants might be small business owners with short-term leases. These types of properties are more susceptible to vacancies and missed lease payments. There’s a greater degree of risk inherent in these leases, so they often have higher cap rates because investors factored in the risk of cash flow volatility.
Most people looking to purchase commercial real estate have a very general understanding of lending, and they’ve usually borrowed money from a bank in the past. However, commercial real estate lending is full of intricacies these borrowers are often unprepared for; having a relationship with an experienced community bank can be invaluable.
Understanding Cap Rates
Again, one of the challenges presented during the commercial loan process is fully understanding cap rates.
Commercial real estate values hinge on a property’s cap rates. The cap rate is the return the market believes the property’s cash flow will provide, and it’s always stated as a percentage (the market also sets cap rates, so they’re easily identifiable). Think of this as the required return for an investor. The cap rate determines the value of the building, and it’s influenced by factors such as lease length, the strength of the tenant’s business, and the building’s location.
Let’s imagine that you have a commercial office building in St. Louis’ Central West End that leases for $55,000 a year and generates $50,000 in net operating income (NOI). It generates a certain amount of cash flow, and that cash flow has a specific cap rate that every investor will target: perhaps 6% or 8% return. To calculate the value of the building, you divide that $50,000 NOI by the cap rate percentage.
For example: ($50,000 annual NOI)/(.8 cap rate) = $625,000 market value.
It can be difficult for business owners to truly understand cap rates. However, this is one of the most important concepts to understand if you’re seriously considering commercial real estate investing. Our experienced relationship lenders are ready to discuss cap rates with you to ensure you’re informed.
What to Know Before Securing Commercial Real Estate Loans
If you’d like to move forward on securing commercial real estate, be sure to first consider these three important factors. Doing so will help you be fully prepared before reaching out to an expert lender:
- Research the market. Understanding the market you’re investing in is critical to success. Property values can vary dramatically in your area depending upon location, traffic counts, vacancy levels, employment, and housing opportunities. Our experienced lenders can help you find the market data that can assist you in your investment decision. We look to establish a long-term relationship, rather than a shorter, more transactional approach. We’ll factor in the market cap rate for the property to help make you more comfortable in your understanding of the reasonable market value for the building you’re interested in. The cap rate drives both sides of the borrowing equation, regardless of what kind of commercial real estate you’re investing in.
- Have your financial information ready. Be sure to have your most recent three years of financial information available. You need to have extensive details on the project, including copies of all leases or detailed rent roll and historical operating statements, so your bank can determine the project’s feasibility. You also need a clear plan for supplying equity in the project, whether that’s in cash, securities, or additional real estate to leverage against the loan. It’s also extremely helpful to determine how you’ll make the down payment. That normally comes from cash savings or other assets (these might include stocks or equity in other commercial real estate opportunities). Investors with a preexisting portfolio of commercial properties can draw on some of their equity to secure a commercial loan for a new property.
- Familiarize yourself with the building. Learn as much as you can about the building you want to invest in. Have a complete understanding of the length of the lease, rent payment structure, and any restrictions regarding access or usage. Also, if available, request financial information relative to the performance of the specific location and/or financials on tenant(s). Be sure to educate yourself about any improvements you might need to make and the costs of those upgrades.
Our experience with commercial real estate lending is extensive, and we’re ready to help lay the groundwork for your investment. Once you have an investment idea in mind, reach out to our experts and get started.