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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   August 2018

Some Financing Deals Gain More Traction Than Others

Owner-occupied transactions are becoming the ‘loans du jour’ of the banking world

Change is in the air. Lenders appear to have commenced a slow transition over the last year toward originating more loans for owner-occupied commercial real estate transactions.

The abundance of “owner-occupied specials” offered by lenders in recent months is emblematic of the shifting focus taking shape. Since the start of the year, lenders’ appetites for investment properties have been waning and owner-occupied commercial real estate transactions are what banks, in particular, are more inclined to approve.

One school of thought is that this sea change is the result of regulators clamping down on the percentage of investment-property loans that banks can hold in their portfolios, while others point out that it’s a byproduct of the stark reality that we may be heading into the tail end of this commercial real estate cycle. Many commercial mortgage brokers likely are finding that banks are keen to originate more owner-occupied deals and scrutinizing investment-property deals more closely.

Relationship banking

Banks pursuing owner-occupied deals are not limiting financing to just U.S. Small Business Administration (SBA) loans, where a lender’s leverage risk is most often limited to 50 percent. They also are offering what can be described as “SBA alternative” conventional financing for owner-occupied deals, with loan-to-value (LTV) ratios up to 85 percent.

The philosophy is understandable. Investment deals routinely only bring into the bank the operating account of the entity that is purchasing the property. There is limited opportunity to develop depositoryrelationships or to offer lines of credit, credit cards, commercial and industrial loans, equipment financing, etc., to such clients, who may own a business unrelated to the investment property.  

Owner-occupied transactions open up op-portunities for banks to cross-sell other products while also bringing a business’s operating account into the bank. This establishes a relationship with the client, not just a one-off transaction, and that is highly desired by all banks.

Cost of funds

From a risk perspective, an owner-occupied commercial real estate deal allows the lender to focus more on the success of the borrower/property owner and the ability of that business to service any new debt, rather than the debt-service coverage ratio of the property, which is calculated using rental income against expenses. Owner-occupied deals also afford another benefit to the bank in the form of recourse against the borrower, the business and any entity that owns the real estate. In the event of a default, this provides added security for the loan that investment properties do not afford.

The real underlying reason for the increased demand for owner-occupied commercial real estate deals, however, is the opportunity such deals provide for bringing in more deposits to the bank. Retail deposits are a cheap way for banks to bolster reserves.

Given the rise in interest rates since last year, banks are less inclined to borrow money in the form of federal funds as those rates have risen. The gap between wholesale costs to borrowers via that market, compared to attracting customer deposits in a retail format, has widened.

The new reality of lenders focusing more on owner-occupied commercial real estate deals is a dramatic shift from prior years, when the appetite for investment properties, was insatiable.

In fact, the fed funds rate, which is controlled by the Federal Reserve, is projected to increase several more times in 2018 and 2019. Hence, banks are seeking a less expensive way to meet reserve requirements and manage the cost of funds while still making sound commercial real estate loans. Enter the owner-occupied commercial transaction to help fill that need.

Deal confidence

At the tail end of any commercial real estate cycle, lenders look at investment properties much more conservatively. They look at the type of business that a commercial tenant operates, the risk of that business defaulting in the current economic environment and the remaining term on the lease. Lenders are less inclined to make a loan on a property when the remaining lease term of the commercial tenant, or tenants, is less than the term being offered under the new ownership. This is especially true if a lender believes a market shift is at hand and the ability to obtain, or retain, a sound tenant could prove problematic.

Lenders also focus on the makeup of commercial-tenant rents versus residential-tenant rents if the property is a mixed-use structure. If the majority of gross rents come from commercial tenants, the inherent risk increases. This is not the case with owner-occupied businesses. In these cases, because the business buying the property is the tenant, lenders are able to assess the trajectory of business revenue and net earnings to determine the future viability of that business.

Many owner-occupied commercial real estate transactions, such as medical-practice deals, are always in demand by lenders. There is stiff competition from a multitude of lenders in that space, however. Other types of deals have gained favor recently as well, including industrial-property transactions and single-tenant deals involving credit-rated tenants.

While certain types of owner-occupied properties and businesses are being aggressively pursued, others have fallen out of favor. Gas stations, hotels and other special-use properties like restaurants are losing traction as this commercial real estate cycle winds down. Many lenders in these spaces have reduced their exposure by dropping their maximum LTVs, while others have pulled out of these spaces entirely.

The change also is evident in the construction market as many lenders are scaling back financings of investment-property construction while increasing owner-occupied construction deals. This makes sense in light of an uncertain economic future, and lenders seem far more confident in owner-user deals, given the cash flow to service the debt is a known factor.

•  •  •

The new reality of lenders focusing more on owner-occupied commercial real estate deals is a dramatic shift from prior years, when the appetite for investment properties, especially in the multifamily sector, was insatiable. The evolution toward owner-occupied commercial real estate by regional and community banks is a reaction to a changing interest rate environment and is based on the assumption that the current commercial real estate cycle is coming to an end. It is a reasonable response. Commercial mortgage brokers should acknowledge this change and act  accordingly by seeking to originate more owner-occupied transactions. 


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