Commercial loans demystifed: Avoid these costly mistakes

So here's the one thing. So for, for your listeners that have stayed, I want to give you kind of the golden nugget for being on this podcast. As long as you have, I have a people investors that have sought out properties that on paper underperform, but they underperform. Welcome back to part two of our conversation with Richard Kimball. Today, we will dive deeper into the specific pains that come without knowing the ins and outs of commercial financing. If you've been wondering about the real cost of staying in uninformed or are curious about the various loan types available, this episode is for you. I would like us to switch gears a little bit to start looking at some of the pains costs and loan types. I know you did touch on a few of them, but I want us to look at those slightly, I guess, dive into it. Yeah. So for let's, let's say for instance, and we are staying, staying on high income investors, right? Because majority of my clients fall into that group. Right. So what are some of the things that end up sabotaging the, the success in even getting commercial lending, commercial financing? Because I know there's going to be some misunderstanding that is going to cause that sabotage. What are some of them in your opinion? Yeah, I think the biggest thing, the biggest reasons or the biggest challenges that you have when you talk about financing these buildings is it's what the seller needs to provide. So we talked about cashflow. So cashflow, whether or not the property cash flows, the bank wants to know, Hey, what are the actual rents? What are the actual expenses? Well, a lot of these, the older owners of buildings. And when I talk about that, I'm not talking about age. I'm talking about, Hey, if I've had my, my six unit building for 20, 25 years, many of those landlords don't even carry leases anymore because I've got the same tenants that have been sitting in those buildings for them to provide us information on what the true rental is. There is tough. And then what the banks typically will ask for first is, Oh, let's see a copy of the seller's tax return as it relates to this more often than not, the sellers are not going to give it to you. It's not happening. We're not giving you our tax returns. Then let's get a copy of the leases that run the property. Oh, we're all month to month because Tony's been here for 18 years. Susie's been here for 10 years. I don't have leases with them anymore. So those become significant challenges for the lenders. And it gets worse when we start saying, you're not going to give us a tax return. What's it take to run this building? What are your expenses for garbage? What are your expenses for water? Are you responsible for utilities? What are your maintenance expenses? What are your management fee expenses? If as a lender can't get a grasp of what that is, it's very difficult for me to make a lending decision on that property. So would you advise that when someone wants to purchase a commercial building, let's say after the enter into contract, they should start gathering that information before we reach out to you immediately. You talked about the pitfalls. I had somebody back out of a building because we had all of the information on this building. So we knew what the property taxes were. We had a good idea of the homeowner's insurance. We knew a couple of the other things. What we didn't know was the utility costs and the seller was dragging their feet to provide. They, they did not have these units separately metered, which means they were the ones that the actual owner of the building is the one that's going to be on the hook for gas and electric and winter time here or the summertime here, depending on if you're heating or cooling, that could be grossly expensive. When we finally got those utility expenses, unfortunately we were smart enough not to spend any of the buyer's money. When we finally got the utility expenses, the buyer just said, Hey, this building doesn't pan out. It doesn't cashflow anymore. Um, so those, the inability to get that documentation is a big deal. So as a buyer going into the contract to answer your question, you want those numbers as soon as possible to make sure this is a good investment for you. That makes sense. And I know then because I've seen instances like that, even for residential, right. And I don't know what I told you this. I own a four unit. So even though it's not commercial, I had to go through the same process by getting the numbers, some of the information, which was very difficult to get, uh, from the seller. So I get it. So when it comes to you, you've given us some of the real life examples. Do you have other real life examples where people have to lose out because they didn't know the right loan types to apply for? Probably something I've had. Some of the bigger misconception is that people, it's really boils down to when they come to us, they go, well, Hey, I'm looking to buy a 20 unit, but I'm only, I heard on a commercial loan I can put 10% down. It doesn't work that way. You're going to have to have 20 to 25% down. Or I heard I can buy a 18 unit, but I have zero rental experience and those are tough deals to get done. The bank's going to want to know that the perfect transition point, honestly, is somebody who's had a bunch of little single families or a couple four units. Now they can transition in to a multifamily commercial. So not knowing what's required can certainly be an issue or having the confusion that you can come to the table with 5% down. That, that's honestly the biggest one. I hear I have five or 10% down and I want to buy a mixed use property. Again, just doesn't work that way. Can we stay on that for, for a minute? Sure. Because I'm putting myself in that and those buyers shoes, right? Because I plan on buying a mixed unit within the next year or two. And as I stated earlier, I currently own a four, four units I've owned it for about four years now. Right. So for a buyer like me, what is this? And the reason why I want the, uh, the mixed unit is because I want to use the bottom section for my business. Right. So as we are discussing this, I'm thinking about the SBA loan, right? So in this case, what are going to be the requirements? I get the cashflow piece and all that stuff. What are the requirements are you going to have for a buyer like me? That's a great question. First of all, one of the things, so your business, let's make an assumption that this is whether this is true for you or anybody else, maybe you're leaving your home and now wanting to put your business in a commercial space. That transition could be a little bit tough for the lender because one of the things they're going to do your personal business tax return is going to have to be viewed because now if you buy this multi-unit building and you say, Hey, I'm going to pay $2,000 a month to rent this commercial space. Well, they're going to want to see your personal tax return to see if you've actually generated enough money to afford a $2,000 a month. So that that's something you'd want to prepare yourself for. It's probably a little bit easier for somebody transitioning out of renting a commercial space into buying their own commercial space versus moving out of their home where they're maybe they're paying themselves rent. Maybe their accountant got cute and said, Hey, you could pay $400 a month and rent to your house and whatever. But the reality of it is the lender is going to go, you can't tell me your business. Patrick is going to pay $3,000 a month for this commercial space. And I look at the tax returns and it doesn't support it. That is going to be a key component. Very much so. Now there are on the flip side of things. There's some commercial buildings out there where the apartments above actually will support the entire building. So I have one of those right now I'm on the South side where the apartments, three of the four are rented and there's enough cash flow for those three of the four apartments on the second floor to support the whole building. Small mortgages under 200,000. Um, but there's enough rent to cover it. Now would that apply for the SBA? That's a little, that's another, another story because again, they want to help the business owner by the commercial space and there has to be some sort of rent. So that would be one where you're going to need my expertise to help get that packaged to the right lender so we could tell the right story around why that makes sense. So for clarification, what I'm understanding is the regular commercial lending, right? As long as the building is going to cash, have enough cash flow to cover the mortgage plus extra, right? It wouldn't matter whether I'm trust transitioning from my home to that office space. Now, when it comes to the SBA loan, from what I'm hearing, there's SBA loan is going to not only look at the cash flow, but also the business entity, which is going to occupy that, right? Yep. Absolutely. Okay. So this is, this is really interesting because now I keep more questions keep coming to mind because I'm trying to put myself into the buyer's shoes, right? So in this case, right, and we are still, I want us to stay on the challenges and some of the pain associated with it. So for, for the long-term financial sequence, consequences of choosing the wrong type for a commercial land of commercial properties, what would be some, some of those consequences, right? If I want to end up with the wrong loan type for any commercial property? Well, I think when you talk about long, we talked about this a little bit. If you think that an SBA loan is going to work for you to buy a multi-unit and eight flat, that's the wrong loan type, right? So when you thought the SBA would help you at 10% get that eight flat, it's just the wrong loan type. Now I don't really know of consequences relative to taking a loan and getting the wrong loan type after that because the bank or lender or credit union or hedge, we know wherever the funds are coming from, they're doing this loan to make sure that the loan performs. So in it's almost they do enough due diligence so that they know that when they closed at least on paper, this thing is set up to succeed. And so that part's important. The only other thing that I can think of relative to what might be, Hey, I'm in this loan and oops, I didn't realize that it was the wrong loan type because my plan was to get out of this loan in three years and maybe it's a five year loan and that's prepayment penalty. That's something that doesn't exist in the residential world but exists fully in the commercial world. Many of the programs, including the SBAs will have some sort of prepayment penalty. So your end game on the property and whether it's to own this property and flip it, whether it's to, and we should talk about this, I want to talk about this opportunity, whether it's to buy it, stabilize it and refinance it, you need to be very aware of what the prepayment penalties are because they could be really expensive. Can you explain that a little bit? Because I think that is that, I guess also falls under miss misconception, right? Because I'm sure a lot of some of my viewers may not have knowledge when it comes to such penalties. So the penalties can range all over the place and so they could be a percentage of the original loan amount. They could be a percentage of the remaining balance. They could be a guarantee that all the interest that the lender was supposed to make over that five year term gets paid. I just ran into one of those on an approval. We have a multifamily product that we got an incredible interest rate at five and a half on. However, for the lender to commit that money at that rate, they wanted to guarantee that they were going to get their interest no matter what happens over the next five years. I see. So that means if the client sells the property in two and a half years, whatever interest was going to be due for the remaining two and a half years, that's the penalty. We have other lenders that have commonly, you'll see something called the five, four, three, two, one. And that's, it's 5% of the balance the first year, 4% of the balance the second year, 3% of the balance the third year. So if you are over $300,000 and you paid this thing off in the third year, 3% is a $9,000 prepayment penalty so that it can be very, very expensive. So good. Now a lot of lenders will let you buy that out and how you buy it out is typically a much higher interest rate. So either a much higher interest rate, and that's dope. Okay. You can buy it out. They may even charge you some points to do that. Um, but there's the prepayment penalty itself is some additional funds that you're going to give the bank because you didn't go the full five year term. So I guess this is great. This, this is actually a good segue to a question that I have in mind, the loan terms, right? I know you've touched on, on it a little bit. What, what is going to be the typical loan terms for commercial properties? Because to your point, let's say for instance, if I decide to pay off three years, depending on the loan type, the loan term that I agreed upon, that is going to trigger either going to trigger the penalty on that based on what I'm standing. So you can touch on the loan, the loan terms and the penalties sometimes that are associated with those terms. I know you've touched on some of them, but can we talk a little bit more about that? I think. So relative to the loan terms is, is an residential loan. Everybody knows what their 30 year fixed is. That's kind of like the all residential lending. When we start talking about commercial, the starting point for all commercial lending is a five year balloon with a 25 year amortization, which means the bank's going to lend you the money for five years. Then they want an opportunity to renegotiate their interest rate and their repayment period instead of being 30 years is 25. Now that shorter repayment period just means that you're able to build equity faster and it also gives them a better position down the road because you're paying the principal down at a little bit quicker pace. So those are two things. The different, that's the template, that's the five 25 the prepayment piece. So you mentioned going into if you were to approach me and you said, Hey Rich, my intention is to pay this thing off in three years. I would literally go back to the lender and say, give me an interest rate or give me a term that's a three year balloon with a 25 year amortization. I'm going to avoid that prepayment penalty because I'm going to create a term that matches what you're looking to do, which is again, that's why it's important to let me know what you want to do. We'll find the lender that's going to create that opportunity for you. We do it ahead of time. So which, which tells me that when it comes to commercial lending, there is still some flexibility in the terms of the loan, right? As compared to, that's based on what I'm hearing. As long as one, I communicate my intentions for that particular property, you know, we, you to help me find a lender, right? That would be willing to work, work with me. I think that I have for that property. Absolutely, Patrick. And I think that is correct. Okay. So we're, if you have specific things in mind that you want to do with this property, not every lender is going to be flexible. So it's important to know that, you know, if you deal with a commercial loan broker, that might be your best bet when you have very specific needs, because otherwise, if you walk into a bank with very, very specific needs, like walking into a random doctor specialist, and let's say you're in to get a knee scope, but we just spun a wheel and you walked into the eye doctor's office. So they're going to be there to help you with your eyes, but you came in for a knee surgery. The same thing holds true with the bank. If you want to work with the bank and you want flexible terms, let's say you're looking for a three year, let's say you're looking for somebody who might give you a little grace on your business. Uh, let's say you're looking for no prepayment penalty, that lender, you just randomly walk into, or even your own bank where you have your checking, your savings or your business accounts. They may be like, Hey, that's great. Patrick, this is what we offer. This is just what it's going to be. This is Patrick. We're offering a five year balloon with a 20 year amortization and we have a prepayment penalty and there's nothing you can do about it. Here's what it is. So you have needs, then you need to find out, find a commercial loan broker who will find you a home for your needs. Okay. That makes sense. We did talk about the regular commercial mortgages, right? And also the SBA. Are there other types of loans? There's a couple, there's things out there. Um, there is some money available for the state for grants that are similar to the SBA. Um, what I find with a lot of government programs is there's a lot of restrictions we had. We were a state grant not too long ago. And the state did some sort of background check on my buyer and they basically rejected my buyer for two reasons. Number one, somewhere like nine years ago, state tax returns weren't filed and something happened with their CPA. Their CPA passed away. They didn't know that he didn't get filed. You know, it's just an unfortunate set of circumstances. And the other thing was they had a very business and that business generated a small claims court judgment, which was immediately paid. I think a vendor of theirs for like 1200 bucks had announced them. They won, they paid it, whatever. But it was a paid claim in the state of Illinois said, Nope, you have those things on you. We're not going to make this. We're not going to grant this money to you. So while there is some things available, I think it's a very, very tough to access to those things that are out there on the commercial side. The only other thing that I would tell you is available out there commercially is on large, large, large multi properties. Um, Fannie and Freddie does have programs for that, but you're talking about minimum loans of $2 million or more. So these are, these are significant. Those loans do have very, very specific prepayment and things cause that interest is expected to be paid and returned to Fannie, uh, Fannie Mae. So there are some products out there. I honestly don't participate in those and those larger, uh, don't participate in those. So when you say larger programs, is it mainly the price of the property or both the price and the number of units? It's a more of the loan amount. Minimum loan amount for those is like 2 million. Okay. So, so you've got a five unit, but let's say if it's 2 million, that is you, you, you classify that as a larger. It could qualify for that Fannie Mae program. But again, there's Fannie Mae, it's relatively restrictive. Um, the, the pricing on it is pretty good. I would honestly tell you that I think that there's commercial banks that would compete with it and be a little bit easier to work with on those levels. So that, that program exists. You asked me about the types that are out there. There is something that's backed by Fannie Mae for large multifamily. It's just not something that we participate in. Yeah. Because the reason why I'm asking is, you know, depending on location, the price is different, right? So that's why I wanted that clarification because at the back of my mind, you know, when I think of a large, I'm looking at the size not necessarily, you know, the cost of the cost of, of, of people, that's, that's, that's helpful. Yeah. These are, these, these are driven for not going to be applying for these. And it's almost what I understand. It's almost cost prohibitive to entertain them until the loan amounts get closer to 3 million. Okay. And on those programs, all of their interest is, so they're, they're, they're lending that with the anticipation that that is going to be paid over the duration of the loan. Okay. So, okay. So it's, the terms are going from the other commercial property types. Correct. You explained earlier. Okay. Correct. You did mention multifamily units, multi-properties. Can you tell us more about the difference between them and office buildings and even retail spaces, the different loan types or how all of these are grouped when it comes to financing? I think we've kind of touched on some of them, but if you focus on, on this, that'd be great. Yeah. So the, the, the first thing Patrick when you're talking about the difference between multifamily retail strip centers or industrial buildings is really choosing a lender that likes that particular product type because not every bank is going to specialize in industrial. Not every bank is going to specialize. There are some banks that don't want anything to do with, with residential multi-units. They don't, they don't want anything to do it. There's other banks that love that stuff, but they would never touch an industrial building. So knowing who wants to do what is really significantly important. Beyond that if the property is going to be owner occupied by a business that has 51% of course there's that distinction. We've covered that. That's potentially qualify for an SBA loan. The last thing, let's say we have a property that's just being purchased for pure investment and we're going to a lender that that will lend on all three of those property types. And then at that point, cashflow, cashflow, cashflow does this property important thing. It's a lot from what I've learned today when it comes to commercial loans or even commercial properties, right? The key thing is to one find the right lender who is specialized in that commercial property type. That's one, two, you also need to understand the requirements, what the lender is going to require from you. Yes. And the purpose of that property, right? As to whether it's going to be purely for rental or you going to occupy at least 51% of the property with your business to operate your business, right? The third is to also make sure, and I said that it's tied to the second, right? In terms of the requirement to get a proper operation numbers, operational on that property from, sorry, from the seller because not all properties are going to cashflow based on, you know, operational cost, right? What else am I a lot of information to process? Yeah, it's perfect. So here's the one thing. So for your listeners that have stayed, I want to give you kind of the golden nugget for being on long as you have. I have, I have a people investors that have properties that on paper underperform, but they underperform because of the reasons we discussed earlier. We've got an older landlord who's had the building for multiple decades and has not brought the rents up to market. Now, what do we know about rents in the Chicagoland area over the last three to four years? There are 30% since the pandemic, but you've got these older landlords that are like, you remember I gave you the example of the, you know, Tom and Susie that have been, and not only are they not renewing those leases, they're not even giving them increases. Perfect example. We have a building that we closed not too long ago, 20 unit building property was great price. As a matter of fact, our bank actually over appraised the property based on what they paid for it. The average rent in the building was about 900 bucks a month. Market says for those units in that area, the market rent was 14 to 1500. My clients are going to buy that while they bought their, they bought the building using our financing. They bought that building and I mentioned the word stabilized before. So now they go into this building. They're going to slowly for the, certainly the tenants that don't have leases, they're going to give them an opportunity to stay and increase the rent to where the market should be. And of course, if they leave, they have an opportunity to go into that unit, update it the way it should be, and now we'll rent it out at the top price. That building once stabilized is going to go from average rent of 920 units to average rent of 15, 14 or 1500. And now they can go back to the lender and say, Hey, I want you to reappraise this based on the new cashflow. Right. It can get their down payment back and probably the capital that they put into it to improve it. And guess what they get to do? Do it all over again. Go find another to do that. So that's a huge deal. It is. And it's interesting example, right? So also thinking about penalties, right? How long will they have to hold it before they go and refinance? Sure. That's a great one. Typically what I would typically, what I advise them to do is go back to the bank that made the original loan. The bank that made the original loan is going to be thrilled that the building got stabilized. They're going to be happy that the thing's making more money and they're going to be more than happy, especially if the loan's performing and now it's the building stabilized, go back to them. They'll give you, they'll give you the money. They'll give you those increases that you're looking for. Okay. So you're in a relationship with them. It's great. Thank you so much, Rich, again, for breaking down the complexities of commercial real estate finance. And I hope my viewers and listeners got a great value from this because I did personally, especially since I'm thinking of purchasing a commercial property in the near future. Rich, can you tell my listeners and my viewers how they can reach you and your team? Yeah, they want to do business with you. Thank you very much, Patrick. I appreciate this and the opportunity. Thank you as always. Anybody who wants some advice on the commercial side, call my cell phone directly. It's 630-291-6012. 630-291-6012. We'll talk about what you're trying to accomplish and we will get you the advice that you need. Find you the lender that you're looking for and hopefully get you into that home run property like we just discussed. Thank you so much, Rich. Thank you, Patrick.