How to Qualify for a Commercial Real Estate Loan
Ready to make the transition from residential to commercial real estate investing? If so, it’s important to understand the difference between a standard residential mortgage and a commercial loan.
Michael Reinhard, a long-time commercial mortgage broker, wrote the successful book Commercial Mortgages 101: Everything You Need to Know to Create a Winning Loan Request Package. In our recent conversation, he provided a crash course on what lenders look for when qualifying a commercial loan.
The first thing Michael emphasized is “that a commercial real estate loan is an entirely different industry than a residential loan.” Residential loans are provided to an owner-occupied buyer or an one to four unit investor, whereas a commercial loan is provided to a five unit or more investor. Michael said, in regards to the residential loan, “Everything you know about and any experience you have with that type of loan – forget about it. Don’t even try to make a comparison. It’s a completely different industry.”
How does a commercial lender qualify an investor for a loan? Here are the five areas the lender looks at.
#1 – Credit Scores
One of the main differences between a residential and commercial loan is the amount of weight the credit score holds. “It’s always good to have a good credit score,” Michael said. “[For] residential mortgages, it’s almost like everything hinges on your credit scores only, and of course income. But with commercial real estate loans, credit score is not the top consideration. It’s almost not important.”
However, if your credit score is below 600, it will raise some eyebrows and require further explanation. If it’s below 500, qualifying for a commercial loan will be difficult.
#2 – Net Worth
When applying for a commercial loan, one of the first things a lender will look at is your net worth. Your net worth is the difference between your assets and your liabilities. Lenders want to see a net worth equal to or greater than the loan amount.
For example, Michael said, “If you’re wanting to buy a $1,250,000 apartment building … in a 80% loan to be a million dollar loan, they would like to see your net worth equal to a million or more.”
However, a net worth equal to or greater than the loan isn’t always the rule. For the example above, you could have a net worth of $600,000 or $800,000, but you need to make up for it with something else. For example, if you have a high income, then net worth isn’t as important.
#3 – Liquidity
Liquidity is also really important. For a $1,250,000 loan, if covering the $250,000 down payment exhausts all your liquid cash, Michael said, “the lenders will look upon that as a little weary because you have no cash left. They don’t like to see someone use up all their cash after a closing and then not have anything for an emergency, such as a $10,000 to $20,000 deductible for an insurance claim.”
The liquidity requirement varies from lender to lender. “The general rule is 10% to 20% of the loan amount,” Michael explained. “If you’re wanting to borrow a million dollars, you have to have at least $100,000 after closing; $150,000 or $200,000 is even better.” Other times lenders may require 6 to 12 months worth of principle and interest payment. If the monthly payment is $10,000, for example, a lender may want to see $120,000 in liquidity.
#4 – Ownership and Management Experience
The lender will also want to know about your ownership experience. Michael said, “Owning a duplex or three or four single-family rentals, or maybe 10 or 12 (you could even have 30 of them) – that’s even better if you have a large portfolio of single-family rentals. But if you’ve only had one or two, and maybe a couple of duplexes, that’s not the same as a multifamily because it’s a little bit different animal.”
If you are purchasing “anywhere between 5 and up to maybe 50 units,” Michael said, “they pretty much allow you to self-manage the property because there’s not a lot of third-party management of that size; it’s just too small and they don’t make enough money on it.” Therefore, since you will be self-managing, the lender will want you to have previous management experience. Do you know about leasing? Do you know how to perform credit checks, verify employment, and run a background check?
if you aren’t managing the property yourself, however, ownership experience will be more important than management experience.
#5 – Income
Finally, the last area a lender will be asking about is your income, whether you’re self-employed or a W2 employee. If you already own a portfolio of properties, they will want to look at your global cash flow, which is how much cash you earn after debt service. If you experience a hardship on one property, they want to make sure you can move cash around to keep all your debt service intact.
Michael said, “There’s really no ratio on [global cash flow]. People ask me about your debt-to-income ratio, [but] they don’t really use that in commercial real estate. They just look at the property’s loan-to-value and debt coverage ratio, meaning how much does the net operating income exceed the monthly principle and interest payment.”
Commercial loans are a completely different animal than residential loans. When applying for a commercial loan, the lender will take the following into account:
- Credit score
- Net worth
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