When it comes to a commercial property acquisition, the typical investor generally spends time performing due diligence. He or she will study the property’s tenants, net operating income, age, location and other information, to make the best investment decision possible.
Then, when it comes to finance the property, that same investor could slap any mortgage on it, without taking into account the myriad factors that might trip him or her up at a later time. But, understanding debt for acquiring or refinancing an asset is just as important as understanding the property itself.
The Purpose of Debt
Debt is, quite simply, an amount of money borrowed. In commercial real estate, debt helps an investor fund an acquisition, or refinance a current loan. Commercial mortgages are issued to entities (such as corporations, trusts or partnerships) and are collateralized by income-producing properties. Lenders, including banks, insurance companies, pension funds and private companies, use that property to secure the loan. If the borrower can’t pay off the loan, the lender can then seize the property.
The loan-to-value, or LTV, measures a loan’s value against the property’s purchase price, or appraised value. For example, an LTV of 80% on an asset with a $100,000 purchase price means the investor borrowed $80,000 to buy the property. Most commercial loans fall into the 65%-80% LTV range. Generally speaking, the higher the LTV, the greater the risk for the borrower.
Debt-Service Coverage Ratio
The lender needs some kind of assurance that a property’s income will be enough to make the loan payments. To obtain such assurance, the lender will compare the property’s annual net operating income, or NOI, to the annual mortgage debt service, which includes principal and interest. This is called the Debt-Service Coverage Ratio, or DSCR.
The DSCR divides the NOI by the annual debt service. A property’s NOI of $120,000 divided by an annual mortgage debt service of $80,000, would equal a DSCR of 1.5. Lenders prefer a DSCR of at least 1.25 to ensure adequate cash flow, with some exceptions.
An investor can be penalized for paying off a loan too early. While this might seem like a bad deal for the borrower, the lender loses revenue from interest payments when a loan is paid off early.
One way to avoid prepayment penalties is through defeasance, which replaces one type of collateral with another that generates the same cash flows to the lender. But defeasance can be costly and time-consuming.
Other factors a borrower needs to consider with a commercial loan include the following:
Loan Assumption. A loan assumption gives the buyer the opportunity to assume already existing debt on a target property, given certain requirements.
Interest Only. The borrow pays only interest at the beginning of a loan’s life. While this can lead to greater up-front cash flow, it can lead to a higher repayment after the interest-only period ends.
Recourse vs. Nonrecourse. Recourse or nonrecourse comes into play if a borrower can’t pay the debt, and ends up having to liquidate the assets. If the borrower has a recourse loan, the lender can come after the borrower for a loan balance not covered with a property’s sale. With a nonrecourse loan the lender can’t come after the borrower for the remaining balance.
In closing, performing due diligence on financing is just as important as doing so on a targeted property for acquisition. Failure to understand the specifics of debt could cost an investor time and money.
Commercial real estate investments can be intimidating. Realized 1031 can help reduce that intimidation with passive commercial real estate investment options. Contact us at 877-797-1031 or log on to https://www.realized1031.com/ for more information.
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