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Understanding Commercial Loan Types and Lenders

Understanding Commercial Loan Types and Lenders

When most potential borrowers think about getting a loan to purchase, construct, or renovate a piece of real estate, the most logical place to start is with a traditional bank.  While they do make real estate loans, they aren’t the only type of lender who does. 

In this article, the different types of commercial loans and lenders are described as well as the pros and cons of working with each.  Let’s start with an overview of the most common loan types.

What Are The Types of Commercial Real Estate Loans?

One way or another, most commercial real estate loans tend to fall into one of four categories:

  • Purchase:  A purchase loan is exactly what it sounds like.  With it, loan proceeds are combined with a down payment and used to purchase a commercial property. Loan terms can vary widely depending on the specifics of the deal, but a “permanent” loan typically includes a fixed interest rate, principal and interest payments, and a term that can range from 5-30 years.
  • Refinance:  Instead of purchasing a property, a refinance is a type of loan where the proceeds are used to pay off another loan.  In commercial real estate, this usually happens in one of two scenarios.  The first is where market interest rates have fallen and there is an opportunity to refinance with a lower interest rate.  The second is when an investor purchases a property with a short term loan, performs some sort of renovations or leasing activity, and then refinances into a more permanent loan.  Again, refinance terms can vary widely, but the loan could have a fixed or variable interest rate, interest only or principal and interest payments, and a term of 5-30 years.
  • Construction:  A construction loan is somewhat unique in commercial real estate lending.  Loan proceeds are not advanced in full at closing.  Instead, they are advanced in “draws” based on stages of completion.  In addition, a portion of the loan proceeds are used to pre-fund an “interest reserve” account from which monthly interest payments are made.  In addition, construction loans usually have a relatively short term, usually 12-36 months with variable interest rates.
  • Bridge:  As the name suggests, a bridge loan is a short term loan designed to “bridge” the gap between two points in a transaction.  The most common use case for this type of loan is to acquire a property, perform renovation, lease it up to stabilization, and then refinance into a permanent loan.  Bridge loans have terms of 12-36 months, interest only or principal and interest payments, and a fixed or variable rate.

The key point is that there are loan types available for nearly every commercial real estate use case and the terms and conditions are tailored to the unique situation presented by the borrower.  In addition, these loans could be provided by different types of commercial lenders.  Seven of the most common are described below.

Lender Type #1:  Traditional Commercial Bank

At the most basic level, traditional banks offer two types of financial products, deposits and loans.  They need both to function.

Short term deposit accounts like checking, savings, and money market, act as a source of low cost capital for loans.  Most checking accounts pay little or no interest while the rate for savings and money market accounts is often less than 1%. Think of the balances deposited in these accounts as the money that banks then lend to borrowers.

With these funds traditional banks make many different types of real estate loans including:  commercial real estate loans, business loans, loans for apartment buildings, construction loans, residential mortgage loans, commercial mortgages, and acquisition loans for other types of commercial property.  

The difference between the interest rate that banks pay to acquire deposits and the rate charged on the loans is how banks make money.

Examples of traditional banks are Bank of America, Wells Fargo, or PNC.  

The benefit of working with a traditional bank is that they are nearly ubiquitous in the United States, offer competitive terms, and allow borrowers to keep their entire banking relationship with one firm.  The challenge is that approval criteria and loan terms can vary significantly from one bank to another so it can be confusing to try and figure out what they are.

Lender Type #2:  Life Insurance Companies

Life insurance companies make money by “writing” insurance policies that provide a financial benefit when the insured passes away.   As part of the policy, the life insurance company charges a monthly premium, which creates large streams of cash flow that the insurance company needs to invest in something that offers predictable returns.  Enter real estate loans.

Life insurance companies offer a number of different financing options, but the most common loans are for commercial properties that are deemed to be relatively “safe” like multifamily apartment buildings or Class A office buildings .  In general, the approval criteria for a life insurance company loan is more stringent than a commercial bank.  So, parameters like the loan to value ratio (LTV), debt service coverage ratio (DSCR), and minimum credit score, are set at conservative values to maximize the chance of repayment in full.

Examples of life insurance company lenders include: PGIM (affiliated with Prudential Life), and Metlife.  

The benefit of working with a life insurance company is that they typically offer long term loans with very competitive terms.  But, the underwriting criteria for approval can be strict.  In general, life insurance companies only work with top notch properties and the most creditworthy borrowers.

Lender Type #3:  Commercial Mortgage Backed Securities (CMBS) Lenders

CMBS lenders are firms who make loans against commercial real estate (CRE) properties and then package them into securities that are sold as fixed income products in financial markets.  

Examples of CMBS lenders include Wall Street firms like Goldman Sachs and JP MorganChase

The major benefit of a CMBS loan program is that the approval criteria are less stringent than a life insurance company or traditional bank.  This is because these loans are packed up and sold in “tranches” which reflect the credit quality of the deal.  The major downside is that CMBS loans can provide a suboptimal servicing experience.  Because they are cut up into tranches and sold to different investors, it can be hard to find a single point of contact to address issues.

Lender Type #4:  Debt Funds  

Debt funds are private pools of capital that are assembled specifically for the purpose of lending it to other borrowers.  Usually, these funds are assembled by large private equity firms like TPG Capital  or the Related Companies.

While debt funds offer many different types of commercial real estate loans, they are a popular choice for construction loans.

The major benefit of working with a debt fund  is that the loan terms and approval criteria may be a bit more generous.  But, they can also be more expensive.

Lender Type #5:  Government Sponsored Entities  

Government sponsored entities like Fannie Mae, Freddie Mac, or even the Small Business Administration provide loans in pursuit of a specific government policy.  For example, Fannie Mae and Freddie Mac were formed with the intent of creating more affordable housing options for Americans.  Or SBA loans are meant to help small business owners with the capital they need to grow and expand.

It is however, important to note that these entities do not make loans directly.  Instead they operate under a delegated model where banks and lenders originate the loans and the GSEs partially or fully guarantee the balance in the event of default.

Examples of GSE lenders include Greystone or Walker & Dunlop

The major benefit of a GSE loan is that the terms are typically very favorable.  For example, in the multifamily space, GSE loans offer some of the most competitive loan terms of any lender.  But, the approval process can be cumbersome and the servicing of the loans can be difficult when dealing with government agencies.

Lender Type #6:  Marketplace Lenders

Marketplace lenders are a hybrid of lender and technology platform.  These companies crowdsource capital from many different individual investors and lend it to borrowers.  They also handle the logistics of payments and loan servicing.

Examples of marketplace lenders include companies like RealtyMogul or SoFi.

The benefit of working with a marketplace lending platform is that they are a good choice for deals with some unique feature or those that may not qualify for more traditional bank loans or commercial real estate financing.  However, they have higher interest rates and typically come with high origination fees.

Lender Type #7:  Hard Money Lenders

Hard money lenders are private firms or private investors who make loans that are based on the value of the property securing the loan, not necessarily the creditworthiness of the borrowerHard money loans are a popular choice as a “bridge loan” that is involved in an investment property fix and flip transaction.  

Examples of hard money lenders are Broadmark Realty Capital or Lending Home.

The benefit of a hard money loan is that they may require a smaller down payment and the approval terms are generous.  But, these loans are expensive.  The interest rates and origination fees are high, which results in a high cost of capital and high monthly payments.  These loans are best for short term situations where some goal is achieved before refinancing into a longer-term loan.

Summary & Conclusion

From this article, it can be seen that there are many different types of commercial real estate lenders who offer many different loan options.  None of these options is objectively better than another, but they may be more suitable for a borrowing or investment situation.  For example, an acquisition loan for an investment property that will be held for a long time may be a good fit for a traditional bank.  Here, commercial real estate investors will find lower interest rates and more favorable repayment terms.  At the other end of the spectrum, a short term construction loan for a deal with some challenges may be a better fit for a hard money lender or a marketplace lender.

For potential borrowers, the important point is that they should look at the characteristics of their own deal and choose the lender and the right loan that is the best fit for their unique situation.