Commercial real estate transactions involve properties that are used for business purposes such as office buildings, hotels, warehouses and vacant land. Buying and selling commercial property involves a more complex closing procedure with a longer list of to-do items than that found in residential property closings.
Commercial real estate transactions require in-depth financial and legal research into the background of the property. Also known as a due diligence investigation, this research goes beyond the scope seen in your typical residential transaction.
As part of the due diligence investigation, specialized inspections of the physical property are required, and a financial analysis including historical and projected income and expense statements for the property must be completed. The due diligence process takes time and can make the closing process for commercial properties significantly longer than that of residential real estate. It’s not unusual for a due diligence investigation of a commercial property to take up to 60 days.
Due diligence investigations can take place either before signing the purchase and sale agreement for the property or take place afterward. Because the due diligence process often reveals certain proprietary trade secrets of the seller, it is not unusual that the seller includes certain non-disclosure and non-compete language either in the sales agreement or in a separate non-disclosure/non-compete document.
Banks have stricter requirements and standards for financing commercial real estate purchases than those that typically apply to residential transactions
First of all, most lenders require that the property be “owner-occupied”. In practice, this often means that 51% or more of the property be occupied by the company that is buying the real estate. Less favorable terms would apply if the purchaser is buying the property for rental purposes and doesn’t intend to occupy the real estate.
Depending on the size of the business making the purchase and how long the business has been in operation, a financial institution may give more or less weight to the following factors before approving a loan for the purchase of a commercial property:
Business finances. Typically speaking, banks consider smaller businesses to be risky investments since many end up folding and thus having a high chance of defaulting on the loan. Larger businesses that have been in operation for longer are generally seen as less risky. To objectively consider the risk involved with loaning money to a business to purchase a property, banks use a calculation called the debt service coverage ratio. The debt service coverage ratio is a company’s net operating income (NOI) divided by its total debt service (the amount the company needs to spend to pay back both the principal and interest on the debt). Banks may require a ratio of 1.25 for a small to medium-sized business in Florida. An example of this calculation in practice would be that a commercial property loan of $2M at 12% APR to an otherwise debt-free small business would require that business to show annual NOI of 1.25 times the loan’s principal and annualized interest. The business may have to show $2,688,000 in annual NOI to qualify for a loan of that size.
“Banks have stricter requirements and standards for financing commercial real estate purchases than those that typically apply to residential transactions”
Business credit. Financial institutions invariably check a corporate entity’s credit score in order to determine a commercial loan’s interest rate, its payback period and the down payment that applies. The FICO Small Business Scoring Service (SBSS), Dun and Bradstreet, Experian, Equifax, LexisNexis and CreditSafe are some of the agencies that banks can use to determine a business’ credit score.
Personal finances. In order to apply for a loan on a commercial property, it is advisable that the purchaser is structured as a business entity. Typically speaking, this would mean that the purchasing entity is a corporation or limited liability company. This avoids risking the personal wealth of the business owner(s) in the case of a loan default. All of this notwithstanding, a financial institution is still likely to consider the personal finances of the business owner(s) as part of the loan underwriting process. Liens, judgements and personal credit issues of the company’s ownership are likely to impact the terms of the loan and may even determine whether a loan is possible.
Collateral. The property itself is seen by the financial institution as collateral for the loan. A valuation of the property and the due diligence documentation of the seller will determine the value the lender assigns to the property and thus impact the terms of the loan.
Company Formation Specifics
Commercial real estate closings usually involve corporate entities as both buyers and sellers. This means that the typical company that is selling or buying a commercial property is a limited liability company or corporation.
Many individuals and existing companies form corporations in order to shelter their liability and benefit from certain tax advantages.
Having corporate entities as the seller and buyer in a transaction requires that the legal advisers to the transaction review the corporate documentation of both sides and determine who has the authority to sign for each of the corporate entities involved in the sale.
The Importance of Legal Counsel
Having the support of experienced legal counsel with a background in Florida real estate law is essential to drafting documentation, reviewing documentation, managing the due diligence process, knowing which entity to form to hold the title of the commercial property and managing lender-related matters.
South Florida Law
South Florida law is a full-service real estate closing law firm that can support both residential and commercial closings. In addition to being a closing attorney, South Florida law is also a title insurance agency. This makes South Florida Law a one-stop shop for all of your real estate transaction needs.
South Florida Law, specializes in conducting title searches on the part of buyers and lenders to ensure the smoothest transaction possible.
Our attorneys have years of experience in handling real estate closing-related matters to facilitate successful real estate transactions. Having our attorneys at your side in a residential or commercial property transaction gives you the advantage of proactive legal protection.
If you are looking for a real estate closing attorney or a title insurance agency, call us today at (954) 900-8885 or reach out to us via our contact form.