How Does Commercial Lending Work?

How Does Commercial Lending Work?

December 30, 2020
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Commercial lenders and car dealers have a lot more in common than you might think. Both will give you a much better deal if they have a lot of inventory and an even better deal if they are forced to compete. In banking and finance, "inventory" refers to the amount of money a bank or lender has available to lend. The more inventory a lender has, the more flexible their rates and terms can be.

Each lender will charge more to a customer who has poor credit and is financially strapped and much less to one who has stellar credit and a ton of cash. These enterprises price their inventory based on the cost of goods. They add on their overhead expenses and as much profit as the market will bear. Both industries know that they have to start out high because they will likely have to come down via negotiating.

How Are Commercial Real Estate Rates Determined?

Almost all commercial lenders base their rates on an index plus a margin. An "index" is an indicator or measure of something. In finance, it typically refers to a statistical measure of change in a securities (stock) market. The most popular indexes are: Treasury yields, the Federal Home Loan Bank rate, the prime rate and the London Inter-Bank Rate (LIBOR).

As an example, let's take a 10-year fixed rate that uses the 10-year Treasury yield as an index, which is at 1.75%. The lender then adds a margin of 2.75% to this. This puts the rate at 4.5%. The margin represents potential profit for the lender.

This index-plus-margin system makes it easier for lenders to sell their rates because the rates appear to be set in stone by a regulated system. Sure, the indexes are tied to a regulated system that does indeed reflect market interest rates. But the truth is, the lender can always add as much to the margin as they want to earn. This is why there is room for you to bargain with them.

When you ask for a better deal a lender will often respond, "Based on our cost of funds, I am already giving you our best rate." Interesting, but as soon as you give them a competing lender's offer, all of a sudden, there is room to negotiate.

Here is how commercial banks and lenders set their rates and recommendations for how much you can bargain with them:

How Much Can Banks Lower Their Rates And Loan Fees?

Commercial banks have risk-based pricing that is controlled by federal regulators. Borrowers who have higher credit scores, higher incomes and more cash get lower rates. If you don't meet these criteria, you won't get the bank's lowest rates, period. Banks have a cost of funds, which is based on what they pay in interest to depositors and/or what they pay to borrow money from the Fed or other banks.

Let's say the bank's cost of funds is 0.75%. It then adds onto this its overhead expenses plus the cost to put a loan on the books. Let's estimate both of these at 1%. Now assuming it wants to earn a 1.75% profit, we are at a floor (lowest) rate of 3.5%. You won't know what the bank's true floor rate is, but you will not be able to go below it. Only its best customers who have large deposits that the bank can lend out at a profit are likely to get this rate.

For all others, the rate might be set at 4.25%. If you can get the bank to compete against another loan offer, it can likely lower this by 0.25%. This might not seem like much to you, but to the bank it is because it earns most of its income from interest over time. So try attacking the loan fee. A bank can more easily lower a 1% loan fee to 0.5%, and if it is competing, maybe remove it completely.

How Much Can Lenders Lower Their Rates And Loan Fees?

Securitized (a loan that can be bought and sold like stocks) commercial lenders include Fannie Mae, Freddie Mac, HUD/FHA and commercial mortgage-backed securities (CMBs). These loans are sold as mortgage-backed security bonds on Wall Street where the investors earn all the interest.

These lenders make all of their income from the margins they charge on interest rates and from loan fees. By getting them to compete, you can likely get a securitized lender to lower their rate by 0.2%.

Again, this might not seem like much to you, but it is not small potatoes to the lender. On a million-dollar loan fixed for 10 years, this can cost them $20,000 in earnings. The larger the loan, the more a securitized lender can afford to lower the rate. But don't expect them to go beyond lowering it by 0.35%. Keep in mind that loan origination fees and interest rates are interchangeable. If you are strapped for closing costs, try to get the loan fee lowered or removed. 

The most important thing to remember is that all commercial lenders — and I do mean all — start out with a higher rate knowing they will have to lower it if there is competition. Don't expect your lender to lower the rate just because you don't like it; that will just annoy them. Always give them another lender's offer to beat. They'll expect this, so don't worry about offending them.

Keep in mind that large banks and credit unions that have too much inventory — in other words, much more money to lend than they have borrowers — are often the most motivated to lower their rates and loan fees. And on larger loans over $5 million, lenders can afford to lower their rates more substantially. This is because their earnings will still be considerably above what it costs them to put the loan on their books.

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