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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   September 2012

Striking the Right Balance

Selecting the right small-balance lender can make or break a deal

Striking the Right Balance

In the past few years, the focus of the commercial real estate industry has been on the capital markets’ recovery, particularly for trophy assets and large loans. All eyes have been on new deals that involve an acquisition or refinance loan of, for example, a $70 million prized asset in New York or Los Angeles.

It’s true, as many commercial mortgage brokers may know, that the best quality assets historically led recoveries in the commercial real estate market — and this recovery is no exception. What has been overlooked, however, is a well-kept secret in the small-balance sector. This sector, which ranges between $500,000 and $5 million, also has experienced a lot of improvement in the past two years. Capital has flowed back into the small-balance sector, and there are attractive financing options for today’s property investors.

"Capital has flowed back into the small-balance sector, and there are attractive financing options for today’s property investors."

The small-business market has seen many changes since the frothy capital markets of 2007. The following are some of the changes in loan underwriting that borrowers and commercial mortgage brokers alike should be aware of when they seek permanent financing for small-balance loans.

Local borrowers: Lenders prefer borrowers to be in the market where the property is located.

  • Post-closing liquidity: Borrowers must have sufficient liquidity post closing — for at least nine months.
  • Schedule of real estate owned (REO): A borrower’s schedule of REO will be carefully scrutinized for performance. 
  • Historical cash flow: The loan will be based on historical operations for the past year, six months or three months (T12, T6 or T3). There is no pro forma underwriting.
  • Cash out: Cash out is difficult to achieve with the typical loan-to-value (LTV) ratio in the 65 percent range with at least two years of seasoning required. Most lenders prefer 10 percent equity retained  in property.
  • Tertiary markets: Lenders prefer markets with a minimum population of 50,000.
  • Nonrecourse: There are less nonrecourse loan options for borrowers for loans of  $5 million or less.

Commercial mortgage brokers play a critical role in ensuring that the loan fits the borrower’s investment goals. By doing so, the broker and the borrower alike will be able to proceed in the right direction and choose the best course of loan execution. There are a few questions that need to be answered before applying for a loan:

  1. What is the borrower’s investment horizon? Understand whether the borrower plans to keep the property for five years or longer, as well as the borrower’s perception of the property in terms of value.
  2. Does the borrower aim at maximum cash flow or principal pay down?
  3. Does the borrower want a recourse or nonrecourse loan?
  4. Does the borrower plan to trade up to a larger property?
  5. Does the borrower want a rate-and- term or cash-out refinance?
  6. Where is the property located? Tertiary markets with a population of 50,000 or less are likely to find it challenging to locate capital sources.

In particular, brokers who work with multifamily must be familiar with a variety of loan-execution styles. With current low interest rates, the opportunity is there for clients who are seeking an acquisition or refinance loan. Here are some tips for working with five common funding sources for small-balance loans.

1. Agency loans 

The Federal Housing Administration (FHA) as well as Fannie Mae and Freddie Mac are actively lending on multifamily properties. For small-balance loans, Fannie Mae may be the primary agency in executing loans in the range of $750,000 to $5 million. Freddie Mac generally does not go below $5 million. FHA loans can be expensive and thus not economical. 

Fannie Mae has the lowest fixed rates, highest LTV ratios and competitive loan terms for small-balance loans. If your deal qualifies, Fannie Mae offers:

  • Up to 80 percent LTV on purchase and 75 percent on cash out
  • 1.25 debt-coverage ratio
  • Fixed rates in the 4 percent to 5 percent range
  • A 10-year to 30-year amortization
  • The prepayment penalty generally is in the form of yield maintenance.
  • Nonrecourse is possible. 
  • Supplemental financing may be allowed after 12 months.

Fannie Mae, however, has more rigid underlying criteria than life companies, banks, credit unions and commercial mortgage-backed securities (CMBS). For example, a borrower must have a net worth equal to the loan amount, a minimum credit score of 680 and at least nine months of liquid reserves. In addition, the borrower must have had ownership of at least two investment properties in the past five years.

If your deal meets these criteria and the borrower’s investment needs, Fannie Mae is a great option, especially on a cash-out refinance. As mentioned, Fannie Mae may lend 75 percent LTV on the appraised value after 12 months of ownership. Not all lenders will allow cash out after 12 months, however.

2. Banks

Many banks seem to believe that the worst is behind us in the commercial real estate market. As a result, banks have increased their funding allocations for commercial real estate over the past 12 months, and have become a major player in the small-balance sector. Some banks offer 80 percent LTV and low fixed rates for solid small-balance loans. In addition, several banks have developed national wholesale programs to the mortgage banker community. Bank rates and terms can be competitive with Fannie Mae, but also offer more flexibility in terms of structure, prepayment and underwriting-based deals.

3. Life-insurance companies

Life-insurance companies have seized a good market share since the market meltdown in 2008 and 2009. They may lend as much as 75 percent LTV, with fixed rates in the mid-4.5 percent range. They will lend on Class-A, Class-B and Class-C assets in most markets, as well. They typically offer nonrecourse, partial or recourse loans — based on the strength of the loan. 


CMBS lenders have tapped Class-A and Class-B multifamily developments starting at $2 million and higher. CMBS lending is a good option for a borrower who may not fit the underwriting criteria of Fannie Mae or life companies but want a nonrecourse loan execution. Rates typically are between 4.75 percent and 5.5 percent fixed for as long as 10 years, and for a 25-year to 30-year amortization.

5. Credit unions

Credit unions are another viable option for small-balance loans. Credit unions primarily are regional in focus and offer bank-like loan terms. The main advantage of credit unions is that they do not have a prepayment penalty. So, if your client is planning to sell an asset in one year to three years, this is a viable option.

• • •

For small-balance property investors, there are a variety of financing executions available. As always, the success of the deal may rest on the skills of the commercial mortgage broker in understanding the borrower’s needs to choose the right financing program.  


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