Turn on the news, and you’ll probably hear conflicting headlines: some say that remote work is “killing office space,” but others are reporting that more and more companies are asking their employees to go back to work. All this uncertainty is creating a tougher approval process in office building financing.
The good news is that while lenders are still cautious, they haven’t stopped lending. They’re just being much more selective about who and what they fund.
They want to know:
Are the tenants occupying the building financially stable?
How long before their leases run out?
If one of the tenants leaves, how much will you need to spend per square foot in upgrades just to convince a new one to move in?
If you can answer those questions based on evidence, you have a better chance of securing office building financing.
What do lenders look at when assessing an office property loan application?
Banks will mainly look at your paycheck and your personal credit score when you apply for a home loan, but when you apply for an office building loan, they care more about how much the building generates in rental income and how much it might sell for should it need to be liquidated. Their main question is: If everything goes wrong, will this building still make enough money to pay the loan back?
To figure that out, lenders look at these:
1. The rent roll
They want to see long-term leases signed by stable businesses. Most lenders prefer leases that extend beyond the early years of the loan, as a near-term cluster of expirations can put too much income at risk at once.
Whether the lender prefers a concentrated or diversified rent roll really depends on the strength of the tenants. In some cases, a handful of established companies may be enough, especially when they have strong financials and long leases. The lender may see those tenants as less likely to miss rent or leave unexpectedly.
But if you’re financing a suburban office building, some lenders will prefer a building with 10 small local tenants over one with a single huge tenant. Why? If one small tenant defaults, you lose 10% of your income. If the only tenant defaults, you lose all of it.
2. The debt yield
Lenders look at this to see what their actual return would be if they had to take the building back tomorrow.
If your building brings in $800,000 a year after expenses and you want an $8,000,000 loan, your debt yield is 10%. Most commercial lenders today want to see at least 9% to 11%. If it falls below that, they might still approve the loan but ask you to put more money down or accept a smaller loan amount.
3. Your personal balance sheet
Even if a loan is non-recourse (meaning the lender can’t come after your personal house if the building fails), lenders will still care deeply about who you are. They want to deal with a borrower who has enough liquidity to cover 6 to 12 months of payments if a major tenant suddenly packs up and leaves.
4. The debt-service coverage ratio
This tells the lender whether the building earns enough to cover the loan payments.
If the property generates $900,000 a year after expenses and the annual loan payments total $750,000, the debt-service coverage ratio is 1.20x. That means the building earns 20% more than it needs to pay the debt.
If the ratio is too low, the lender may reduce the loan amount or ask you to put in more cash.
5. The loan-to-value ratio
This compares the loan amount with the building’s appraised value.
If the property is worth $10 million and you want to borrow $7 million, the loan-to-value ratio is 70%. Your equity covers the remaining 30%.
A lower ratio gives the lender more protection if the property loses value. A higher ratio may lead to a larger down payment.
6. Your experience as a borrower
Lenders want to know whether you have owned or managed a similar property before. If this is your first office property, they may look more closely at the property manager or operating partner you plan to use.
Which type of office financing will fit your project?
You need to choose a loan product that matches your strategy for the property.
In general:
If you own a business and want to buy our own building, you will benefit from an SBA 504 loan (low down payment, fixed long-term rate). As long as your company occupies at least 51% of the building, you can put down as little as 10%.
If you want to buy and manage a building that is fully leased and bringing in steady cash, you may qualify for office financing from banks and other traditional lenders.
If you want to buy a half-empty office building to renovate and lease up later, bridge loans can buy you that time. The rates are higher, but approval is faster. They can be very beneficial if you have a solid exit strategy.
Does the type of office building matter when it comes to financing?
Yes, because lenders don’t see all office space the same. (1) Where your building sits and (2) who uses it can change how much a lender is willing to finance.
Medical office buildings are attractive to lenders because they tend to be stable. Patients have to see doctors in person and medical equipment is expensive to move, so medical practices rarely leave. It’s easier to get better rates and higher borrowing limits in this segment.
Suburban multi-tenant office buildings are also viewed more favorably, especially when income comes from several established tenants. The diversified rent roll spreads the risk, so lenders may be more comfortable with the loan.
Downtown high-rise office buildings have seen quite a slump in recent years, so many lenders are exercising extreme caution in this segment. Big corporate towers are also expensive to maintain. With corporate leases shrinking, there’s no telling how easily you can replace a departing tenant. That’s not to say that loans aren’t available; you can still get financing, but you may need a larger down payment.
How do you get approved for office building financing?
Prepare a financing package that shows that you’ve thought through the risks. The materials should explain:
Why will tenants stay in the building?
What makes this location work?
What does the property’s cash flow look like? At least three years of historical operating statements is ideal.
Who are the tenants? Include information on their financial strength, what they pay in monthly rent, when each lease ends, and other key lease terms.
How will you handle vacancies? Show bank statements or other records proving that you have the cash reserves to handle unexpected tenant turnover.
If you’re exploring office building loans, don’t hesitate to send your project details to our team here at Private Capital Investors.
