Posted by Mike Langolf ● Oct 7, 2020 9:00:00 AM
What are the Differences Between SFR and SBC Loans?
First off, lets start by defining the terms SFR and SBC so we are all on the same page:
- SFR (Single-Family Residential): An investor owned single-family residence that is NOT owner-occupied. An SFR rental is a residential property that is owned and operated as a rental unit(s) (1 to 4 units).
- SBC (Small Balance Commercial): An investor owned cash flowing commercial property that has a market value between $300,000 and $3,000,000. The property type itself may be multifamily (5+ units), retail, mixed-use, office, warehouse, light industrial, flex space (warehouse and office), or self-storage.
On the surface, there is not much difference between a typical investor loan secured by an SFR (single family residence that is non-owner occupied) and an investor loan secured by an SBC (small balance commercial) asset. Both types of loans are secured by a mortgage or deed of trust (depending on the location of the property) and the borrower is usually a single asset limited liability company that owns the subject property.
So, in this blog we will explore the similarities and differences that are typical of a private lender underwriting a standard SFR loan and a standard SBC loan (note each lender has its own underwriting guidelines which may differ from the information contained herein).
Comparing Underwriting the Borrower and Guarantor Processes for SFR and SBC Loans
The underwriting standards of the borrower and guarantor will be very similar with SBC and SFR loans. The greatest differentiators are between banks and private mortgage companies. Private mortgage companies tend to be more asset based when underwriting a loan. This differs greatly with a bank, as a bank typically is underwriting a loan and looking for three sources of repayment, which are the cash flows from the property, global excess cash flows from the borrower and/or guarantor and finally the liquidation of the collateral in the event of default. Private lenders, for both SFR and SBC loans, rely heavily on the property cash flow to cover the loan payments and the value of the subject collateral in relationship to the loan amount (loan to value or LTV) in the event of a default. And while a private lender will review a borrower/guarantor’s credit report (and fraud reports) many do not require submission of tax returns, nor do they require a global cash flow analysis with supporting documentation.
A Look at Underwriting the Collateral for SFR vs. SBC Loans
Underwriting a cash flowing SFR or SBC property are similar in that the underwriter is reviewing the rental stream. In both cases you have a lease or leases identifying the tenant(s) and the agreed upon rental payment in exchange for use of the subject property or a portion thereof. Cash flow from either an SFR or an SBC property will be the primary factor in determining the value of the property along with the property’s ability to cover loan payments.
In an SBC asset, you are more likely to see multiple leases for a single asset (i.e. a multifamily building, a small retail strip center, etc.). Most assets that fall under the general definition of Small Balance Commercial will have relatively simple operating cash flows much like an SFR asset. So, the approach is very similar to SFR underwriting, except you are now looking at several leases that comprise the cash flow and that need to be reviewed and underwritten. In addition, the quality of the tenant in an SBC asset is under much more scrutiny because it typically is much easier to replace a tenant in an SFR property than a tenant in an SBC property. Under most SBC leases, you are not going to be able to underwrite the tenant’s financials, so an underwriter will be reviewing the length of time the tenant has been in place, the remaining term of the lease, the lease economics and the tenant’s payment history. This is critical when the space has a specific use, such as a restaurant, where conversion to another commercial use may not be financially viable. Contrast this with a standard 50’ x 100’ retail bay with a restroom and back office. This type of space provides flexibility for a potential tenant, who may want to use the space for an insurance or realty office (assuming the use is allowed under the local zoning laws) as opposed to the retail shop. The flexibility of the space along with local market conditions (i.e. vacancies) are critical to the review of the property to determine the likelihood of finding a replacement tenant for a vacant bay.
In an SFR asset, the layout of the house will be critical in determining how attractive the home will be to a new renter. For example, if the one-bedroom home is in a highly rated school district, this property maybe harder to rent, as it is not attractive to families with school age kids due to the lack of additional bedrooms. This along with the local area vacancy rate will be critical in underwriting a loan.
For both an SFR and SBC asset demonstrating that the rental income will continue to be on-going and attractive to other tenants in the event of a vacancy is critical to the underwriting of the asset.
What to Expect in Appraisal Reports for SFR and SBC Properties
The primary difference between the two asset classes is the type of appraisals that are required.
For an SFR asset, private lenders will typically order an appraisal based on a FNMA (Fannie Mae) Form 1004. This type of appraisal is a standard form and uses three methods to determine the asset value. These three methods are Sales Comparison Approach, Income Approach and Cost Approach (note the last two methods are not required by FNMA for conventional residential financing). The indicated values of the three methodologies are then reconciled by the appraiser to determine the appraiser’s opinion of market value. An appraiser will require the borrower provide the asset address and purchase contract (if applicable). A SFR report is typically a 7 to 10-page form-based appraisal compared to a SBC appraisal which is a narrative report that typically is upwards of a hundred pages. The SFR report is usually around $350 to $500 with a 7 to 10-day turnaround time.
For an SBC asset, the lender will order an Appraisal Report that must comply with both USPAP (Uniform Standards of Professional Appraisal Practice) and FIRREA (Financial Institutions Reform, Recovery, and Enforcement Act of 1989) requirements. The Appraisal Report will contain the above mentioned three methodologies to determine the indicated value of each method with a final reconciled market value as determined by the appraiser. To complete the report, the borrower will typically provide the asset address, purchase contract (if applicable), leases and other documentation that support both income and expenses of the property. The Appraisal Report takes the form a narrative appraisal where the format is determined by the appraiser as long as all the requirements of both USPAP and FIRREA are included. An SBC appraisal report will typically range from $2,500 to $5,000 with a 2 to 4-week turnaround time.
As you can see, the methodologies essentially the same, with the required borrower supplied documentation, report format, cost and completion time being the primary differences.
Small Balance Commercial Properties Also Require Environmental Reports
Typically, an environmental report is not required for an SFR asset, so you can see why many residential mortgage brokers may be put off by SBC loan requirements for an environmental report. But the fear is unfounded as we have moved away from the old requirements of a lengthy Phase I Environmental Report and, if needed, a Phase II Environmental Report. Private lenders are now ordering concise environmental reports that are form based and provide a score from 1 to 5 to determine the level of environmental risk associated with an asset. These reports are relatively inexpensive (+/- $200) and can be completed in a matter of days. Of course, these basic reports are fine for low risk assets, such as multifamily, retail and office. Other property types, which are typically excluded by SBC lenders, such as gas stations, dry cleaning plants and heavy industrial properties will require the completion of a Phase I Environmental Report and most likely a Phase II Environmental Report.
Loan Documentation is More Complex for SBC Properties
Basic loan docs (note, mortgage or deed of trust, personal guaranty, assignment of rents and leases, etc.) are going to be very similar regardless if the loan is secured by an SFR property or an SBC property. Both sets of loan documentation will conform to all lending laws to perfect their interest (lien) in the subject property. Since the SFR loan, under our assumptions, is an investor loan and not owner-occupied, you will not necessarily see all the consumer disclosures as required by law.
The difference in loan docs between an SFR and SBC asset start to emerge as the complexity of the asset increases. While the loan documentation package will be very similar between an SFR and a small multifamily property, that changes drastically with assets, such as, large retail centers with credit tenants, large office buildings and other specialty properties (i.e. hotels, warehouses, gas stations, etc.). Additional documentation for these type assets may include tenant estoppels, non-disturbance agreements, complex environmental indemnity agreements, lock box agreements, and so forth. These types of complex documents are reserved for properties that are not typically seen in the SBC world.
SFR and SBC lending is very similar in that one must understand the cash flow generated by the subject property. Hopefully, my goal of demystifying small balance commercial lending will inspire residential mortgage brokers to add SBC loans to their product offerings. I would encourage residential mortgage brokers to survey their clients and find out which of them owns or is looking to purchase small multifamily buildings (5 – 50 units) or mixed-use properties (with residential and retail units in the same property) as a entry point into SBC lending world. We are finding that many SFR investors own or are looking to own these type assets. Do not let the perceived complexity of an SBC asset scare you away from adding these loan products to your offerings and expanding your business.
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