While investing in commercial real estate can bring rich rewards, there are also fundamental risks. Firstly, commercial properties require ongoing maintenance and upgrading and can depreciate sharply if a competitive product is built in the area. Another issue is that the sheer value of a commercial property makes it challenging to afford, requiring greater finance and resulting in a down payment dilemma.
The down payment dilemma in commercial real estate transactions revolves around the fact that high down payment requirements prevent some potential buyers from investing, but obtaining a loan with a low downpayment creates potential cash flow problems for the buyer and a greater risk of failure.
A downpayment is effectively a deposit on the purchase of a property and achieves specific important goals:
It proves the buyer’s commitment and reinforces his ability to buy the property. Secondly, the downpayment, by reducing the loan amount, reduces monthly payments, interest costs for the borrower, and the risk for the lender. But there are dilemmas to be resolved, too, and it’s those I’m going to cover.
The Down Payment Dilemma In Commercial Real Estate
An investor investigating different property sectors, including residential and industrial real estate, faces the dilemma of how much down payment is needed in commercial real estate.
High Prices Require Large Down Payments
With commercial properties being, by their very nature, substantially more expensive than residential properties, they require a more significant financial commitment. For the smaller investor, that means borrowing more and finding a bigger lump sum to put down as a deposit.
Lenders Require A Higher Percentage Down Payment
Where banks and other lenders are prepared to accept 10% down payments, or even less, on residential loans, the norm for commercial property is between 25 and 30%. This requirement makes it even more difficult for small investors to get into this property segment.
Accepting A Lower Down Payment
There’s an associated dilemma facing investors, and that is whether to pay a smaller amount as a down payment if agreed by the lender but pay a higher interest rate. The buyer will, in all probability, also need to pay mortgage insurance until the loan-to-value ratio (LTV) is below 80%. This puts a strain on cash flow, costs more in the long run, and increases the risk of failure, but it does offer the buyer an opportunity to finance the purchase.
The Dilemma Of Quality Vs. Down Payment Requirements
Clearly, quality commercial real estate is highly sought-after, and competition between investors equates to higher prices. The dilemma for investors is whether to sacrifice quality for affordability and invest in cheaper properties where the financial requirements are more easily met.
The Dilemma Of Time Vs. Lost Opportunities
While trying to accumulate sufficient cash or equity to meet down payment requirements, an investor has to forgo all the opportunities that arise and stay out of the commercial property market. The dilemma that he faces, though, is that the market may be rising, and prices increasing faster than his ability to raise the down payment.
Commercial Real Estate: Solving The Down Payments Dilemma
If the down payment requirements on a proposed commercial property transaction are preventing you from concluding the sale, or if, as an investor, you are unable to find sufficient equity, there are options to consider.
SBA Loans Require A Smaller Down Payment
The Small Business Administration is a body set up to assist small businesses in acquiring commercial properties, but only in situations where the small, for-profit business will occupy at least 51% of the building for their own operation. The interest rate charged on SBA loans is usually the lowest available to buyers but is not available to investors or speculators wanting to rent the building or resell it for a profit.
The SBA loan typically requires only a 10% down payment and can be used only to purchase, refinance, or develop commercial real estate.
Conventional Banks Have Strict Requirements
While traditional banks offer excellent rates, particularly to their most valued clients, they are strict regarding their requirements. Borrowers have to provide an unblemished credit history, proof of income and expenses, and a valuation of the property. Commercial real estate loans are usually made not to individuals but to business entities.
To grant these loans, the banks require that the annual income generated from rentals and other sources is between 8% and 10% of the loan. The repayment period on commercial is typically between 5 and 20 years. The repayments may be for a period of, say, ten years, but that repayment amount is based on the loan being amortized over 20 years. The balance due at the end of the ten years is then payable in one balloon payment.
Coupled with this, the LTV the bank requires is between 65% and 80%, so while their rates are attractive, traditional banks require a hefty down payment of up to 35%. The dilemma lies in balancing these pros and cons.
Private Lenders – An Expensive Solution To The Down Payment Dilemma?
Non-bank lenders comprise individual lenders or institutions that provide hard cash loans for owner-user and speculative investors in commercial property. Their requirements are usually less restrictive, with down payments often as low as 15%, with repayment terms more generous than the banks, at least in terms of the loan period, which can be up to 20 years.
While these terms are all negotiable, and decisions are made quickly, there is a cost: interest rates are higher based on the borrower’s credit rating, the type of business, and the risk to the lender. Coupled with the lower down payment, this translates to substantially higher monthly repayments, and the borrower needs to be sure that the income from the investment is secure and sufficient to meet the higher figure.
Strength In Numbers
Possibly the most straightforward, least risky way of overcoming the down payment problem when investing in commercial property is to play the numbers game, not by gambling, but by:
- Joining forces with other investors to pool resources, combine income streams, be in a position to offer more than minimum equity, and negotiate the best possible terms with the bank.
- Buying small commercial properties initially and taking advantage of market opportunities to build up a portfolio of successful investments will then provide the necessary equity to qualify for the required finance on the more significant deals when they arise in the future.
Conclusion
The down payment required by lenders in a commercial real estate transaction has several functions but essentially reduces their risk. At the same time, it reflects the financial strength of the purchaser and their ability to afford the repayments and other expenses involved in the deal. Resolving the dilemma of how much the down payment should be is a calculation requiring a great deal of skill and expertise.