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I wanted to spend some time this morning talking about some of the pros and cons of debt and leverage when it comes to commercial lending.
One of the first things customers typically ask me is how much financing can they get against a certain type of property. Typically, the question is something along the lines of “How much do I need to put down for this apartment building acquisition?”. Or if they are looking to refinance, “How much cash-out can I get with a refinance, namely how high a loan to value can you get me to?”.
Although these are important questions and something every borrower needs to understand, it is only part of what you should be thinking about. Let me try to explain.
What you first need to understand is that each institution typically has both a policy and a practice of how much leverage they will allow a customer to have. Their policy provides a maximum limit to what they will allow. As an example, a lender may have a policy not to advance more than 80% of value against an owner-occupied commercial property, however, as a practical rule, they may market that they will only do 75% of value. This is because they want to reserve the 80% for their best customers only. These policies and practices will limit what different lenders can get done.
Some lenders may even issue an internal practice that is different from their policy due to market conditions. One community bank in Chicago right now will not advance more than 65% to 70% against owner-occupied commercial properties at the moment because management is concerned businesses are going to continue to struggle due to the pandemic. It may seem like a strange decision, but that is what that Bank has decided to do right now.
But the question you need to ask yourself if you are looking to borrow money, is what type of leverage makes sense for you? Keep in mind, higher leverage transactions typically come with higher interest rates and they also come with higher risk. Here is an example of how interest rates can be impacted.
Via the SBA 7A loan product (which is a product provided by the Small Business Administration) if an existing business is trying to buy a property they operate out of, in some circumstances the Bank will allow the Borrower to finance up to 100% of cost to acquire that property. However, this loan product typically comes with a variable interest rate that is usually slightly higher than market. Obviously being able to finance 100% is maximum leverage but does it always make sense to do so. If a Borrower lacks money to put down and would be saving money by owning versus renting, then maybe it does make sense to use this product. We used this product earlier this year for one client looking to expand their tire business to allow them to buy the location they operate out of with 100% financing. They have additional expansion plans and using 100% financing helped them save money to fund those future plans.
However, there is another SBA product called the SBA 504 product that is also used to finance owner-occupied commercial properties. That product requires 10% down, but it comes with a long-term fixed rate versus the variable rate on the SBA 7A product. If the same tire company wanted to put 10% down instead of 0% down, they could have locked in a long-term fixed rate that was lower than what they got on the SBA 7A product. In theory the SBA 504 product made more sense for the tire company in the long-run, but in the short-term putting less cash down was more important to them.
Another example is that most Banks will not do cash-out on commercial or investment properties above a 60% to 70% loan to value. However, we have non-bank lenders that will go up to a 75% loan to value. For the loans from non-bank lenders the interest rates can be anywhere from a half percent to two percent higher than the traditional bank products. Borrowers need to analyze what they can afford and what makes the most sense for them in the long run along with what they can use the money for they are cashing out.
I want to mention we do a fair amount of apartment building financing. Right now, due to higher demand for apartment buildings, we are seeing many buildings trade at values above what their cash flow can support. In order to make the loans underwrite it requires our customers to put more than 25% down. Our customers are having to make the decision whether to put more down because they really want the building, and it would be worth it in the long run or walking away and trying to find another building that is cheaper. The building might value out for the purchase price, but that does not always mean current cash flow would support that purchase price.
Lastly, keep in mind the more leverage you have on a property the less you are going to pay down during the initial typically five-year term of your commercial loan. Most commercial loans do not have terms that extend beyond five years. When your loan matures five years from now, you may have a higher loan to value if you put less money down. If values have gone down, that could put you in a situation where the loan to value is now too high for your bank or another bank to refinance, and you may be forced to put more money down at that time. We have not really seen any of this happen over the last 10+ years because values have been steady and gone up, but this was a common occurrence coming out of the Great Recession where Banks refused to renew loans without a principal reduction or additional collateral due to a loan to value being too high. The more money you put down, the less likely this will be a concern in the future.
If you are ever looking to understand all of your options and compare different products, your payments, and what they will cost you long-term, we are always here to help. I can be reached any time at 630-988-4852 or via email at firstname.lastname@example.org