Securing commercial loans through conventional lenders isn’t always possible, often because the property doesn’t qualify, the borrower has a poor financial history, or the space is unoccupied. One financial test conventional lenders evaluate is the debt service coverage ratio (DSCR). If a property doesn't meet a certain threshold, you won’t be able to get a loan for it. Recently, the global pandemic has caused an increase in vacancies and a reduction in rental income, which lowers the DSCR and disqualifies many commercial properties from conventional loans. More people are looking for private funding, which is one reason hard money investing is on the rise.
Even if a borrower is able to get a loan through a conventional lender, they might need to act more quickly than the bank’s process allows. If you have equity, private lenders offer an alternative that allows you to get fast cash when a real estate opportunity arises.
The Commercial Loan Process
Investing in commercial real estate debt can generate attractive risk-adjusted returns provided the underwriting is done well and the loan is structured properly. The lender should ensure that they will be insured for a clean title and always get a third-party appraisal, preferably from a Member Appraisal Institute (MAI) certified company.
The other key thing to understand is what the borrower's plans are for the property. Is the property currently leased, vacant, underdeveloped, or undeveloped? Know what kind of project you are stepping into prior to making the loan because you might ultimately be the one to finish it.
Every potential borrower is vetted during a rigorous underwriting process that evaluates factors such as:
- Appraisal and assessment of the property
- Loan amount or loan-to-value
- Borrower equity in the property
- Credit quality and financial strength
- Loan terms including interest rate, loan duration, fees, and holdbacks
If the borrower is approved, the lender decides which investors are best suited for the loan.
Just like you would diversify your portfolio of investments, you also want to ensure that you maintain a diverse portfolio of hard money loans. As you invest in the commercial loan space, make sure you're constantly reevaluating your portfolio and testing for over concentrations. Some common tests include the following:
- Asset class - Some lenders may specialize while others look for diversification. Socotra Capital funds a combination of multifamily, residential, industrial, retail, and office properties.
- Geographic - Some lenders will control the number of loans they have in any one market. If there is a natural disaster or other local event, having loans spread out geographically can help protect investments
- Borrower concentration - Although repeat borrowers are allowed to have multiple loans, lenders may sometimes limit the number of loans they have with any one particular borrower in order to avoid any potential disruptions to their business.
- Loan size - Lenders will also have a range of loan sizes that they target with minimums and maximums. Socotra Capital can finance most loans from $100,000 up to $20 million.
As with any investment, you should always be evaluating the level of risk you are taking with the return you are getting. Investors in private debt tend to gravitate towards residential properties because they perceive the risk to be smaller—mostly because residential properties take less time to liquidate. While commercial properties can take more time to sell, they still possess a good store of value and if a loan is underwritten properly, can ultimately deliver attractive risk-adjusted returns.
As it gets more difficult to buy commercial properties through conventional lenders, more people are turning to private lenders because of the many advantages they offer. In addition to being able to get cash quickly, many properties that do not qualify for a conventional loan can be purchased through a private lender when the borrower has sufficient equity. These dislocations in the credit market can create unique opportunities for private lenders to fill in the gaps left behind by traditional banks and commercial lenders, provided the borrower has sufficient equity in their property.
If you would like to learn more about how you can make money on commercial loans as an investor, get in touch with Socotra Capital today.