Commercial Real Estate Mortgages: The Quick and Dirty
A commercial mortgage, like a residential mortgage, is a loan made using real estate as collateral except in the case of the commercial mortgage the real estate is a commercial property. Unlike a residential mortgage obtained on your home which is relatively straight forward in nature, the process of obtaining a commercial real estate loan / mortgage is generally more complex and can be considerably more daunting especially for the first time purchaser of commercial real estate. . This article is specifically targeted for those first time purchasers as opposed to those who have previously been through the process however even in this case it will hopefully serve as a good refresher. This article will be in 2 parts: Part 1 will outline what one should know when applying for a commercial mortgage and Part 2 will review the key criteria the lenders use to qualify a commercial mortgage (to be printed in this publication at a later date).
There are a many different types of properties that fall within the realm of commercial properties such as: apartment buildings, multiplex residential units, industrial & manufacturing facilities, commercial office buildings, store front retail with apartments, industrial & retail condo units, vacant land zoned commercial (serviced or non-serviced), special purpose buildings like medical facilities, nursing & senior homes, large scale commercial recreational properties ( golf courses, camp sites) etc. The type of commercial property purchased or refinanced is one of the many factors that will directly impact the lenders key criteria used on the mortgage application & assessment as will be explained in Part 2.
The customer’s reason for purchasing the commercial property is also a very important consideration and clearly needs to be understood at the outset. For example the property purchase may be for relocation of the purchaser’s operating business (owner occupied) due to the company’s growth & expansion and / or it may be strictly for investment purposes & taking advantage of market timing & prices to generate rental income and longer term capital appreciation, wealth building or retirement & tax planning. Whatever the reason it is important for it to be understood as this too will also be a key factor in the mortgage proposal & application and lender assessment.
Part 1: Preparing for the Offer to Purchase and Mortgage Application
Purchasing commercial property entails a rather long list of things that the purchaser should know and have prepared prior to making an application with a lender. Such things include: the application process and the time it takes lenders to review, ensuring that appropriate conditions are set in the Offer to Purchase, the documents the bank will require, a general idea of all the bank & 3rd party costs to be incurred, the 3rd party reports that will be required and approximate cost & timing to complete, a good understanding of cash flows from either rental income and / or from the operating company relative to debt servicing the new mortgage, the key financial criteria the bank or lender will use to qualify the application, the collateral security the bank will generally request in addition to the property, the other loan covenants the lender will generally apply in most cases. These comprise the main items however it is by no means an exclusive list. A first time buyer would not necessarily know all this information thus it is strongly recommended that prior to making an Offer to Purchase the purchaser should arrange a meeting with a lender or a mortgage broker to review and be guided through the process. In fact it is preferable & recommended that the purchaser consult a mortgage broker specializing in commercial mortgages first rather than going directly to a Lender as this will enable the purchaser to approach the deal from a position of strength & preparedness and increase the chances of the application being seen in more favorable light by the lender. Let’s examine these areas in greater detail.
In the majority of cases the lender will take considerable more time completing due diligence on commercial loan applications than residential home mortgage applications as there is a lot more information to review & secondly the risk to the lender is generally much higher. Thus a more detailed and thorough due diligence is undertaken. On average commercial mortgage applications will take anywhere from 30 to 90 days for the bank to carry out its due diligence. This could be for a multitude of reasons such as information requested by the lender is provided piecemeal versus all at once; the property Appraisal & Environmental assessments & property inspections by 3rd parties requires time to book and have completed; financial statements of the borrower and/ or the property operating statement are not completed and ready to be given to the bank. These are just some of the things that usually cause delays & extend the lender’s decision on the application. For this reason the purchaser should make sure that the condition for finance date on the Offer to Purchase allows sufficient time for the diligence to be carried out. Alternatively the buyer should have a good idea on the amount of flexibility the Vendor will extend on amending the finance & closing date conditions etc.
The lender will request the purchaser to provide an abundance of information & documentation including: the Offer to Purchase and MLS Listing, the type of commercial property and intention for use, the operating statement of the property ( if a rental / investment property) and the financial statements of the purchaser’s business/enterprise ( if property will be owner occupied); usually 2 years statements information is the minimum but some lenders’ will insist on 3 years if applicable, the purchaser’s personal net worth statement showing all personal assets & liabilities, the property survey certificate, the last tax statement, the rent roll & all leases (if a leased property), the last Appraisal & Environmental reports if available, and the mortgage statement of any outstanding mortgages on the property. Again these comprise the main items that are normally requested however there could be others.
The purchaser should have a clear understanding of cash flow & the lender’s cash flow criteria relative to the new mortgage debt. This can entail 2 parts depending on the planned use of the property. If the commercial property purchased is strictly an investment property with rental revenue then the net operating income & cash flow needs to be reviewed and understood to ensure there is sufficient debt servicing capacity relative to the lender’s debt servicing coverage (DSC) requirements. Alternatively, if the property will be owner occupied (purchaser relocates his business in the property ) then the operating statement of the business becomes the key item to review for cash flows. The purchaser must have a reasonably good knowledge of the business cash flows & its operating statement to ensure the new mortgage debt in conjunction with all other company liabilities and debt payments will be adequate to provide debt coverage & meet the lender’s DSC criteria. Most companies have seasonal fluctuations of cash flow relative to the type of business, selling periods & account receivable cycles & collections etc so it is critical that the purchaser know in advance that sufficient cash surplus be available throughout any given period to meet monthly debt & mortgage commitments. In some cases when the property will be both owner occupied and leased (owner occupies part of the space and leases out the other space) then the combination of the rental revenues ( property operating statement) and the business’ cash flows need to taken into consideration & used to prove DSC.
The purchaser should be aware, so it will not be a surprise at a later date, of the other collateral security in addition to the property that the lenders generally request. If the lender is institutional such as a bank or insurance company then normally a personal covenant or guarantee will be required. The amount of the guarantee will depend on the overall risk assessment of the deal & amount of the mortgage. At the very least a guarantee of at least 50% of the mortgage amount should be expected. If the property will be occupied by the purchaser’s business then a guarantee will also be required from this company as it is the company that is generating the income to service the mortgage debt. In addition to this security the bank will require property insurance be in place for at least an amount covering the full mortgage advance. If the mortgage is provided by a private lender then the requirement of the personal guarantees may be waived or reduced from the amounts that the institutional lenders would require.
In addition to the above, the purchaser should be aware of the general covenants & reporting requirements that the lender will include in the mortgage loan agreement. The general covenants will list the events of default that will trigger a demand for mortgage pay out and / or commencement of Power of Sale by the lender. Thus it is very critical that the purchaser review this mortgage commitment in detail so no unexpected surprises will arise later. It is recommended that the purchaser have their lawyer or mortgage broker review the mortgage commitment agreement prior to signing as often through negotiation with the lender some of the covenants & reporting requirements can be waived and / or amended to be more flexible.
In summary, the first time purchaser of commercial real estate may be aware of some of the areas covered in this article but likely not entirely knowledgeable of the full process. Being prepared and having this information in advance will circumvent many problems, delays & uncertainties along the way and provide the purchaser the information needed to make an informed decision. This obviously is a preferable method as opposed to going about it in a haphazard manner. The purchaser can go directly to a lender and obtain the information he needs to proceed with a purchase and the mortgage application or consult a mortgage broker. While both options are available it is recommended that the purchaser consult a mortgage broker specializing in commercial mortgages as this will provide the purchaser with more options & essentially a one stop shopping advantage. The mortgage broker has access to many lenders who have several different commercial mortgage products with varying terms, conditions & rates and can usually find the best fit for the mortgage deal. The mortgage broker has the experience, the platforms & contacts to source the deal to the right lender allowing a stronger proposal / application & obtain the mortgage approval required. By leveraging the experience of a mortgage broker the purchaser will save considerable time and headaches and in most cases will receive a better overall deal versus undertaking the process on his/ her own.
In Part 2 we will review the commercial mortgage from the lender’s perspective and outline the key criteria that Lenders use to approve a commercial mortgage.