What you need to know: Commercial real estate loan mistakes like ignoring your DSCR and underestimating closing costs could cost you a lot of money down the road. Worse, you might even lose a deal. So before applying for a loan, check your numbers and plan your exit strategy. Just as importantly, read the loan terms carefully and base your repayment plan on realistic cash-flow projections. Private Capital Investors can help you secure a commercial real estate loan that fits your needs.
Getting a commercial real estate loan is never as simple as finding a property and filling out an application. There’s a lot to prepare, and even a small mistake can create expensive problems, especially as you move toward closing. Even if you have a strong property and a promising business plan, something as simple as missing paperwork or unrealistic financial projections can slow down your application or even lead to a rejection.
Apart from the property, your lender looks closely at the numbers and your plans for repaying the loan. If something doesn’t add up, you could end up borrowing less than expected or paying a higher interest rate. Worse, you could lose the financing altogether.
Knowing the most common commercial real estate loan mistakes ahead of time can help you avoid unnecessary costs. This knowledge will also put you in a stronger position when you approach a lender.
Mistake 1: Ignoring your debt service coverage ratio (DSCR)
Before you apply for a commercial real estate loan, make sure you know your DSCR. This number tells you and the lender about the property’s ability to generate enough net operating income (NOI) to cover its loan payments.
Many lenders want to see a DSCR of at least 1.25x (the higher the better).
If you don’t check your DSCR before applying, you could ask for more financing than what the property’s income can support. This could leave you with a smaller loan than expected or make it harder to qualify.
So, when your DSCR comes up short, look for ways to increase your NOI. You might cut unnecessary expenses or negotiate better terms with vendors. You could also request a smaller loan amount or consider a longer repayment period if the lender offers that option.
Mistake 2: Having no exit strategy for a bridge loan
A bridge loan is short-term by nature. Naturally, your lender needs to know how you plan to repay it when the loan comes due.
Maybe you plan to renovate and stabilize the property before refinancing into a longer-term loan. Or perhaps you plan to improve the property and sell it. No matter what your plans are, you need to show the lender that you have a realistic path for getting out of the bridge loan.
The mistake is assuming that everything will happen exactly when you expect it to. The truth is that you can never truly tell when renovations might run behind schedule or if your property takes longer to sell. Refinancing may not even be available on the terms you expected.
So besides spelling out how you plan to repay your bridge loan and when, tell your lender what you plan to do if the original plan takes longer than expected. Having a backup plan shows the lender that you’ve thought beyond the best-case scenario and have another way to repay the loan in case the deal doesn’t move according to schedule.
Mistake 3: Underestimating closing costs
It’s easy to focus on the purchase price and down payment and forget how much money you’ll need to actually close the deal.
Commercial real estate closing costs can add up quickly. Depending on the transaction, you may need to budget for:
- Loan origination charges and lender legal fees
- Commercial appraisals and environmental assessments
- Engineering and property condition reports
- Property-related expenses, from the title and escrow to ALTA surveys and endorsements
- Professionals you might hire, such as an attorney and accountant
- Due diligence
- Insurance prepayments and prorated expenses
- Required reserves and capital expenditures
Usually, closing costs can run around 2% to 5% of the purchase price, although every deal is different. On a $1 million property, that can mean tens of thousands of dollars on top of your down payment.
If you underestimate those costs, you could reach closing without enough cash to complete the transaction. You might manage to close, but you could run out of reserves for other expenses like repairs and vacancies when you put nearly all your available cash into the deal.
So always work out your expected closing costs and leave some room for expenses you didn’t anticipate before committing to the property. You should also find out which costs you can negotiate and which ones you’ll need to pay regardless. This should give you an idea of how much cash the deal really requires instead of budgeting around the purchase alone.
Mistake 4: Choosing the wrong loan product
When you’re trying to close a deal quickly, it can be tempting to take the first financing option that looks workable. But rushing this decision can leave you with a loan that doesn’t actually fit your investment plans.
An interest rate may look attractive, but what about the fees?
You also have to check how long the term is and your ability to repay it early. The last thing you want is to discover restrictive terms after you’ve already signed the agreement.
Take the time to compare loan products and lenders before making your decision. If you’re working against a tight deadline, a broker or financial advisor may also help you compare several financing options more quickly.
Mistake 5: Missing prepayment penalties
You could sell the property or refinance before your loan matures, but be sure to check the prepayment terms before signing anything. Some lenders may charge a penalty when you repay your debt earlier than agreed. Depending on your loan, this penalty can add a significant amount to the price of selling or refinancing.
Switching lenders before the loan term ends can also trigger a prepayment provision. The same thing could happen if you sell the property and use the proceeds to clear the balance or when you pay down more of the loan than your agreement allows.
Lenders calculate the costs differently, so you may come across several structures:
| Prepayment Structure | What It Means |
|---|---|
| Step-Down Penalty | The penalty falls over time, such as 3% in year one and 2% in year two. |
| Yield Maintenance | You may have to compensate the lender for interest it loses when you repay early. |
| Defeasance | You replace the property collateral with qualifying securities, which can also add transaction costs. |
| Lockout Period | You cannot prepay the loan for a set period. |
Before agreeing to a loan, think about when you may want to sell or refinance. If you expect to exit the property in a few years, compare that timeline with the loan term and prepayment rules.
Most importantly, read the prepayment section carefully. You want to know what an early exit could cost before you need one.
Mistake 6: Not structuring the loan request properly
Make it clear how much you need and what you’ll do with the money when you submit a commercial real estate loan request. You also need to tell your lender how you expect to repay it.
This is especially important when you’re taking out a bridge loan. If your application leaves questions about loan amount and use of funds, the lender may need more time for underwriting. You could even hurt your chances of approval.
Make sure you have the documents the lender needs before submitting a request. Depending on the deal, you could include property information and appraisals. You can also provide your financial statements and details about your previous borrowing or commercial real estate experience to reassure the lender.
Keep everything organized and make the numbers easy to follow, so your lender can understand everything without filling in the blanks.
Mistake 7: Picking inappropriate collateral
Your lender wants some protection if you can’t repay the loan, and that’s where collateral comes in.
Real estate is an obvious example, but lenders may also consider assets like your equipment or inventory, depending on the commercial loan. In any case, you must ensure that your collateral is suitable for the size of the loan that you’re requesting. An asset that isn’t worth enough to support your loan can weaken your application.
The type of financing you choose can help you decide which collateral to use. With a construction loan, you could expect different collateral and funding requirements, unlike when you need to finance an existing, stabilized commercial property.
Find out exactly what the lender accepts as collateral and how they’ll determine its value before you apply. This can save you from putting together a loan request that doesn’t meet their requirements from the start.
Mistake 8: Not saving enough for the down payment
Most of the time, your commercial real estate loan won’t be able to cover the entire cost of the property. You still need to bring a substantial amount of your own money to the deal.
The typical down payment could range from around 10% to 30% or more, depending on the financing. Some SBA loan programs may even qualify you to put down around 10%, while conventional commercial financing may require considerably more.
Say you’re buying a $2 million property and your lender requires 25% down. You’ll need $500,000 for the down payment alone — and that doesn’t include everything else from the closing costs and reserves to the repairs or other expenses associated with the deal.
That’s why you want to work out your cash requirements early to find out what your lender expects. From there, you can make sure that you have enough money available by closing.
This becomes particularly important with construction financing, since you might face additional upfront costs as your project moves forward.
Mistake 9: Not understanding the loan terms and conditions
Avoid signing a commercial real estate loan agreement without understanding what you’re agreeing to. Otherwise, you might overlook the terms that could cost you more money later.
Pay close attention to details such as:
- Prepayment penalties that could bring additional costs if you sell or refinance, or even repay the loan earlier than expected.
- Variable interest rates that could change your payments as market rates move.
- Loan terms that could affect your payments and force you to refinance sooner.
- Balloon payments that could increase your debt when the loan matures.
If there’s something in the agreement you don’t understand, ask about it before signing. You need to know what the loan costs today and what it could cost you throughout your investment.
Mistake 10: Being overconfident about your ability to repay
It’s natural to feel positive about a commercial real estate investment. However, don’t assume that everything will go perfectly and then build your repayment plan around that idea.
Maybe you expect rents to increase quickly or the property to stay fully occupied. Doing renovations? You can’t expect them to finish exactly on schedule. When your assumptions don’t work out, you still need enough cash flow to make your loan payments.
So, be sure to have realistic cash-flow projections based on numbers you can support instead of being overly optimistic about the best possible outcome.
Two things can help:
- Run realistic cash-flow projections – Look at your property’s current or historical performance and account for everything from vacancies and operating expenses to repairs and other potential costs.
- Use a commercial real estate loan calculator – This can help estimate your payments before you borrow anything. Likewise, it can help you see how changes in rates or terms could affect what you owe.
It also helps to run a few less favorable scenarios, like when a major tenant leaves or construction takes longer than planned. You should also consider the possibility that your variable interest rate may increase.
If the deal only works when everything goes according to plan, you may be taking on more debt than what your property can comfortably support.
Need a commercial real estate loan?
Talk to us here at Private Capital Investors about your property and financing needs so we can help you secure the capital you need for your commercial real estate project. Get started by calling 972-865-6205.
Sources:
- https://lnkd.in/p/gyn3iicp
- https://www.lendingtree.com/business/prepayment-penalties/
- https://www.commercialrealestate.loans/commercial-real-estate-glossary/Prepayment-Risk-in-Commercial-Real-Estate/
- https://www.linkedin.com/posts/jordan-suber-9614a3264_why-most-cre-deals-fail-at-closing-its-share-7408177653922328576-UjJv/
- https://www.rok.biz/top-mistakes-to-avoid-when-applying-for-a-commercial-property-loan/
- https://bigpropertyfinance.co.uk/news/top-5-mistakes-to-avoid-when-taking-out-a-bridging-loan/#fifth
- https://rcncapital.com/blog/common-mistakes-to-avoid-when-applying-for-a-bridge-loan
