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Five worst mistakes when financing commercial real estate

Environmental clean-up, detailed appraisals, lack of information and high closing costs can disrupt the transaction
financing commercial

1. Thinking that the costs are the same as residential financing.

There are much higher costs involved when purchasing a commercial property as compared to a residential property. Costs include a commercial appraisal ($2500 to $3500), environmental report ($2500 to $3000), lender and broker fees (generally 1.5 per cent to 2 per cent) and legal costs of the lender and borrower, which are charged to the borrower’s account.

2. Not allowing enough time for subject removal.

I can usually obtain a discussion paper for a client within seven to 10 business days, on an income-generating property (construction is more involved, and takes more time); however, a discussion paper is not sufficient reason for a client to remove financing subjects. In order to remove financing subjects, a client requires a final commitment from a lender. A final commitment for commercial financing on an income-generating property generally takes about five to six weeks to put into place. The length of time varies depending on a number of factors:

• How long it takes for the client to provide all the requested personal and corporate information.

• How long it takes the seller to provide the property information.

• How long it takes to obtain a commercial appraisal and an environmental report.

A common mistake investors new to commercial real estate make is assuming they can put in an offer, and remove subjects within two weeks, or feel pressured to do so by their realtor.

I see this a lot from investors that are new to commercial property investing. The problem is that they then have to go back and ask the seller for an extension, which opens them up to possible renegotiation of a variety of items that were agreed to in the purchase contract.

Tip: Lenders will generally accept an existing Environmental Phase 1 report.

Clients can save a substantial amount of time and money if they request in their purchase offer that the seller provide a copy of the existing environmental report. 

3. Not having proper financials in order.

 If a property is being purchased in a company name, lenders always require accountant-prepared company financials, so a purchaser needs to make sure that they have current year-end financials on hand, as well as any in-house interim statements (if several months have passed since the company’s year-end and the current date).

Otherwise, they will need their accountant to prepare the financials, and this can cause several weeks’ delay in lenders being able to issue their discussion paper, and ultimately their final commitment. In addition, the income and expense statements for the property being purchased need to be in order and up to date.

I often see sellers providing the purchaser with very poor or incomplete property income and expense statements, and this will lead to delays and/or the difference between getting an approval or not. If a client presents shoddy financials for the property, the chances are we will not be able to obtain financing approval for the purchase.

4. Accepting that projections for the property will suffice. 

For income-generating property, all commercial financing is based on the actual current net income of the property, and what loan amount the net income shows it can service. Lenders will base their decision solely on the actual net income of the property and will not use a client’s projections for a property. Borrowers can show fantastic projected cash flow after they do the intended renovations, increase rents and/or lower expenses, but this will not be taken into consideration by the lender for financing purposes.

Tip: If current rents are well below market, and the net income does not show that it can support the requested loan amount currently, it might be best to suggest to the client that an interim solution (typically one year) will be required to assist in the acquisition/renovation of the property now, and once the situation is rectified (rents are increased, expenses reduced), and the net income shows that it can support it, then institutional term financing can be put into place. 

5. No experience with that type of commercial property. 

I see this for all types of commercial property, including apartment buildings, mobile home parks, hotels/motels, and construction. Largely, this problem can be mitigated by showing experience with other rental property, or business experience, and/or by putting a reputable property management company in place.

Where construction is concerned a developer’s lack of experience, can often be mitigated by hiring a reputable project manager and builder, or by partnering with an established developer for the first project.

Lenders basically want to know that a developer has the financial strength and cash liquidity to be able to withstand any cost overruns or unforeseen problems with the project.

Tip: Sometimes, especially where the property is a hotel/motel or a mobile home park, the lack of experience issue can be offset by having the existing owner stay on for a period of time as a consultant to assist with the transition.

Michael Lee is a mortgage broker with Mortgage Alliance Commercial Canada, based in Port Moody, B.C.