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Commercial Land: The Asset That Lenders Forgot

My home loan is at 6% and you are telling me that a lender wants over 10% for a land loan?  The loan is made to the borrower, not the property.  Commercial real estate makes great security for a lender because it produces income that can make the loan payments until the property is sold, in the event the borrower defaults.  Not so, land.

Last week I discussed the financing of the purchase of a residential lot for development with a woman who, with her husband, wanted to build a custom home.  As always happens when discussing financing, the conversation turned to interest rates and loan structures.  When I described the going rate for a fully indexed land loan on a residential lot, she darn nearly fainted!

She spluttered:  “Wha … How could rates possibly be so high?!?  My home loan is at 6% and you are telling me that a lender wants over 10% for a land loan?  That is ridiculous!”

Well, not really.

I understood her confusion, but she was comparing apples to oranges.  From an investor’s standpoint, land is a great investment for a number of reasons:  “They” are not making any more of it (except possibly in Dubai), you can put your hands on it (it is “real”), no one can pick it up and take it away without a mounting a stupendous effort, and eventually it will be worth more than you paid for it (in most cases).  However, when we look at land from a lender’s perspective, it is leaves a lot to be desired.

When making a loan, the lender’s primary objective is to get paid all of its interest and principal.  The lender relies on the borrower to fulfill his obligations under the note, but asks for some “insurance.”  That insurance comes in the form of a lien on a real property, called “securing” the loan, and is the lender’s last resort in the event the borrower can’t pay off his loan.  The loan is made to the borrower, not the property.  It is secured by the property in the event the borrower defaults on the loan.  So a lender looks for the best security that it can find to ensure that it will be paid back.

Commercial real estate makes great security for a lender because it produces income that can make the loan payments until the property is sold, in the event the borrower defaults.  Homes are also great security because there is usually an active market in which to sell one and a borrower is likely to do everything he can to keep his primary residence.  Even owner-occupied business property is a good bet for a combination of the reasons above.

Not so, land.

Land, for all of its potential value, just sits there.  No one lives on it, no one works on it, tumbleweeds roll across it, and unless it is used as a parking lot or a swap meet, it produces no income.  Add to these challenges the reality that the process for converting land into income producing or residential property takes a great deal of effort, specialized knowledge, and time.  Most lenders really do not like these characteristics in their security and thus, don’t lend on land.

As a result, when faced with taking land as security for a note, those lenders who do make loans on land do a couple of things to mitigate their risk.  The first is that they usually reduce the loan to value significantly.  The more equity you have in the land, the bigger the discount they can offer to a buyer when selling it and the safer they feel in making the loan.  Note that this was not the case in my opening example.  That particular lender had a specialized program that would have loaned up to 90% of the value of a finished lot, but it was for residential, owner-occupied development.

The second thing a lender does is increase its rate of return to match the perceived risk of disposing of the property in the event of a default.  If a lender gets 12% to 14% on its money for a land loan, it receives its invested dollars faster, even though we call them “interest.”  This reduces the lender’s exposure faster and provides a risk-adjusted return when the loan is paid off.

So the next time you contemplate financing some land, just remember that your lender will be looking at it from a vastly different set of circumstances than you.  Done that wayHealth Fitness Articles, you probably won’t cough loudly when he quotes you the rate! 

Source: Free Articles from ArticlesFactory.com

ABOUT THE AUTHOR


WANT TO USE THIS ARTICLE IN YOUR E-ZINE OR WEB SITE? You can, as long as you include this complete statement with it: ‘“The Investment Property Insider” is published by Craig S. Higdon, a veteran commercial mortgage broker. He publishes the weekly e-zine and blog, www.InvestmentPropertyInsider.com, for commercial real estate investors, developers, and industry professionals. Visit the blog and get this free report: “The 7 Biggest Loan Mistakes Real Estate Investors Make and How to avoid them.”’



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