When most real estate investors want to borrow money, they go to a bank. However, due to a variety of reasons, many commercial real estate investors cannot secure bank loans. Instead, these individuals need to find alternative sources of debt financing, options savvy investors should understand. We’ll use this article to provide an overview of these non-bankable commercial real estate loan options.
Specifically, we’ll cover the following topics:
- What Makes a Commercial Real Estate Borrower Non-Bankable?
- Non-Bankable Commercial Real Estate Loan Options
- Non-Bankable Loan Considerations
- Final Thoughts
What Makes a Commercial Real Estate Borrower Non-Bankable?
What Does “Non-Bankable” Mean?
Non-bankable simply means that you cannot secure a real estate loan from a traditional bank (e.g. national, regional, or local banks). Broadly speaking, a deal becomes non-bankable for one of two reasons. One, something about the borrower disqualifies him from a bank loan. Or two, something about the deal disqualifies it.
Common Reasons for Non-Bankable Status
Credit issues and bankruptcies. Commercial banks have strict personal underwriting standards. That is, the underlying borrower must meet certain credit requirements. Even though commercial banks loan to business entities (e.g. LLCs), they still generally require a personal guarantee or carve-out that forces that person to pay back the loan in case of default. If borrowers have poor credit or a recent bankruptcy, the bank will likely disqualify them from a commercial loan. If the deal makes sense, commercial hard money and private money lenders (discussed below) will potentially disregard these issues when approving a loan.
Past-due taxes. A large past-due tax liability will also often disqualify a borrower from a bank loan. First, this liability speaks to unreliability as a borrower. Second, it means that the IRS likely has a claim against your assets. Any outstanding IRS issues have a tendency to scare off lenders, as they don’t want their loan funds or underlying collateral tied up in a dispute with Uncle Sam.
Criminal history. Whereas the above issues speak to financial reliability, criminal history pertains to a potential borrower’s morals. If a borrower has been convicted of past crimes of “moral turpitude” (generally considered violent felonies and crimes of dishonesty), they will be automatically disqualified from securing a commercial real estate loan (or any loan) with a bank. Of note, crimes of moral turpitude will likely disqualify borrowers from all loan options – bank and non-bank alike.
Requested loan size. Many banks have a target loan range. Too small, and the bank can’t justify the costs associated with originating the loan. Too large, and the bank’s balance sheet may skew too far away from liquidity requirements. Accordingly, many non-bank lenders offer loans outside of these bank ranges.
Timing. Frequently, closing on one real estate acquisition depends on the sale of another. That is, the proceeds from a sale will go towards the cash requirements for the next purchase. Most banks don’t have the flexibility to offer contingent real estate financing in these sorts of situations. On the other hand, some of the non-bank options discussed below are tailor made to provide this bridge financing.
Lack of common equity. Commercial real estate deals often include a variety of debt and equity financing sources, all of which have unique terms and protections. Lenders generally require a baseline percentage of common equity in the deal (e.g. 10% or 20%). However, many deals include a mix of preferred equity and hybrid, mezzanine-style financing in addition to common equity. If these “intermediate” financing options translate to a lower-than-required common equity stake, the deal may not meet a bank’s underwriting criteria.
Non-Bankable Commercial Real Estate Loan Options
If either the borrower or the deal itself precludes traditional bank loans, the below non-bank loan options still exist. Not all of them apply to each of the above scenarios, but commercial real estate investors should have a solid grasp of each of these non-bank options.
Bridge loans serve as a short-term financing tool until investors can secure permanent financing (i.e. a long-term mortgage). While individual terms vary, bridge loans in commercial real estate typically have terms from three months up to three years. And, unlike more permanent financing sources – which can take a long time to close – you can close on a bridge loan far more quickly.
Commercial Hard Money Loans
A common misconception exists that hard money loans are so named because of the difficulty in securing them. Rather, the name comes from the fact that approval for these loans rests solely on the hard asset, that is, the underlying commercial real estate.
With hard money loans, non-bank companies review applications based on the value of the underlying real estate – not the borrower’s financial situation. Hard money lenders will commission a commercial real estate appraisal to determine the property’s value, and they’ll offer a loan based on this appraised value. Depending on the particular deal and lender, borrowers may secure a hard money loan for anywhere from 60 to 80% loan-to-value (LTV). As with bridge loans, hard money loans typically include far shorter terms and higher interest rates than a conventional mortgage.
Commercial Private Money Loans
Private money loans function in the same manner as commercial hard money loans. That is, private money lenders offer shorter-term, higher-interest loans based on the asset itself. The difference exists in the type of lender. Whereas companies act as hard money lenders, private entities (e.g. high-net-worth individuals or family offices), as the name suggests, issue private money loans. This difference means that many private money lenders have more underwriting flexibility in issuing loans, as they lack the institutional guidelines and restrictions of hard money lending companies.
Debt funds offer another non-bank source of commercial real estate loans. These funds, backed by private-equity capital, lend money to offer short-term financing for real estate deals. Depending on the debt fund’s objectives, these loans may be issued to sponsors looking to acquire properties or to those who currently own real estate but need to access additional financing. As with most private equity models, the underlying investors in the PE fund receive payouts based on the periodic interest the debt fund charges the real estate borrower. In the process, the PE firm managing the debt fund itself collects a fee.
Historically, insurance companies – not banks – have issued some of the largest commercial real estate permanent mortgages. These companies collect massive amounts of money via insurance premia, and their actuarial tables require a certain rate of return on those funds. However, due to the insurance industry’s nature (i.e. needing to pay out claims), these companies need to minimize risk. As a result, insurance companies will underwrite and issue large, long-term commercial real estate loans. These lower-risk loans on highly reliable real estate deals effectively function as bonds for insurance companies, providing stable, reliable returns over the mortgage loan’s term.
Non-Bankable Loan Considerations
Upfront Costs & Higher Rates
The above shorter-term options (i.e. bridge, hard money, private money loans, and debt funds) charge higher interest rates than a bank’s permanent mortgage products. Depending on the deal and individual borrower, these loans may have rates anywhere from 3% to 10% above market rates for permanent ones. Additionally, these loans often include high closing fees – another cost to consider in a commercial real estate underwriting model.
While many non-bankable loans come with higher costs, these lenders also generally have far more deal flexibility. Traditional banks have strict loan underwriting criteria. If either the borrower or deal falls outside those guidelines, the loan won’t be approved. Non-bank lenders, on the other hand, often have the flexibility to offer creative financing solutions, solutions that can account for both borrower- and deal-specific issues precluding a bank loan.
A borrower or deal may not qualify for a bank loan for a variety of reasons. Fortunately, alternatives exist. The non-bankable commercial real estate loans discussed in this article offer other options for securing financing. While each of these loans has its advantages and disadvantages, real estate investors should have an understanding of each option.
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