Commercial Real Estate Lending Explained
As a business owner, your top priority is to grow your business. Purchasing new property or renovating it is a great start in establishing yourself in the commercial world. However, you will need financing, and your regular home loans or mortgage will not work out.
With commercial real estate lending, investors and businesses can purchase or renovate business-related properties. Much like residential loans, they are secured loans where the property being purchased acts as the collateral.
If you consider a commercial real estate loan for your business, here’s everything you need to know before you step foot in the action.
This article takes you through commercial real estate lending: Commercial loans, types of commercial real estate loans, qualifications, important loan ratios, repayment schedules, interest rates, and much more.
We will be considering the following main topics:
- What Is Commercial Real Estate Lending?
- What Is a Commercial Loan?
- Important Loan Ratios
- Types of Commercial Real Estate Loans
- How Much Will My Bank Lend for Commercial Property?
What Is Commercial Real Estate Lending?
Commercial real estate lending is similar to mortgage loans. However, they are given to companies to purchase properties for business purposes.
Commercial real estate is a property used exclusively for business prospects or as a workplace rather than a living space. It includes housing, retail sales, manufacturing facilities, medical facilities, restaurants, recreational parks, retail sales buildings (such as shopping centers and malls), warehouses, etc.
Sources for Commercial Real Estate Lending
Apart from a commercial bank, the following also act as sources for commercial real estate lending and provide capital:
- Credit Union
- Private investor
- Small Business Administration (SBA)
- Pension Fund
- Private Company
- Life Insurance Company
- Crowdfunding or Online Peer-to-Peer (P2P) Investing
What Is a Commercial Loan?
Just like with home loans, banks and financial institutions also provide loans on commercial real estate.
Commercial loans are typically secured loans where the property being purchased is used as collateral. They are designed to help companies purchase or renovate commercial real estate properties and refinance real estate debt on already-owned commercial property.
Commercial real estate loans are made to corporations or businesses that own and operate commercial estate. The large size of the loan poses a potential risk to the lender. Hence, they require a more significant down payment when compared to residential mortgage loans.
How Does a Commercial Loan Work?
Much like your residential loan, every lender has different terms and accepts various risk levels. However, the repayment terms of commercial loans are much smaller. The term can range anywhere from 5 to 20 years. In this case, the amortization period is longer than the loan term.
For example: Consider a CRE loan with a term of 7 years and an amortization period of 30 years. Here, the borrower makes regular payments for the first seven years. Then finally, they make a balloon payment comprising of the remaining balance.
These loans are generally more expensive, with the down payments ranging between 20% to 30% of the purchase price. In addition, the interest rates are again high at 10% to 20% for most borrowers in the same line. However, loans backed by SBA tend to be cheaper at 7.75% to 10.25% depending on the size and length of the loan.
Importance of Commercial Real Estate Loans
Commercial real estate loans are a critical part of the economy. They are generally much bigger than the residential loans making for a bulk part of the income for commercial banks and other lenders. Furthermore, nearly all businesses seek financing to be able to operate firsthand.
Commercial real estate loans are actively sought for various reasons:
- Companies seeking to purchase a warehouse, workspace, or manufacturing space
- Businesses seeking for financing to acquire rental property
- Housing development companies looking to fund a new development project
Qualifications for Commercial Real Estate Loans
Commercial real estate loans are not as easy to get as residential loans. Every lender has his own qualifying criteria. Here’s how you qualify for a commercial loan:
- Good Credit History: To start with, you will need a credit score of 680 or higher. For credit approval, your history should be devoid of foreclosures, recent tax liens, recent bankruptcies, etc.
- Low Loan-to-Value (LTV) Ratio: LTV ratio determines the amount of equity or collateral a borrower has in a given property. Those seeking a commercial real estate loan require a minimum of 65 – 80%.
- Down Payment: A bank may expect a down payment of at least 30% for these loans. However, in the case of SBA loans, it is 10%. Keep in mind that a lower down payment relates to higher monthly payments.
- Organized Paperwork: An organized application and the required documents may make the difference between your loan approval and rejection.
- Business Entity: Commercial loans are available for entities and not individuals. So ensure that your business entity is set up before applying.
- Joint Venture Loan: In case you are not able to secure one as a single entity, you can join forces with someone else and seek a joint venture loan. This would effectively make you both partners.
Make it a point to write down the qualifications of different lenders, both your bank and other online lenders, as you shop around. This helps you compare and choose the one with less stringent requirements.
Loan Repayment Schedules
In short, you pay monthly payments for the repayment term and then a final balloon payment at the end. Again, not all lenders allow you to pay the amount early. Here are some potential charges you may encounter:
- Prepayment Penalty
- Interest Guarantee
Interest Rates and Fees
Commercial real estate loans have higher interest rates than mortgage loans averaging at 5 – 7%. SBA 504 loans provide a lower interest rate, below 3%. Depending on your loan type and structure, lenders may go lower than the average range.
Coming to fees, you may have to pay closing costs (appraisal, origination, legal, and application fees) and more. It can amount to 1 – 2% of the commercial loan amount. In addition to that, you may also have to pay a guaranty fee that can cover a portion of the loan. It can be as high as 3.75%.
Prepayment penalties and prepayment fees can also be costly, depending on the lender’s size and the financials of your business.
Read the fine print to understand how much you might be charged if you choose to pay off your debt early in a commercial real estate loan. Commercial real estate loans do not require private mortgage insurance, so that’s one less thing to worry about.
Important Loan Ratios
Not just commercial real estate loans, every loan is based on the loan-to-value ratio and the debt-service coverage ratio. These ratios help determine the loan size and the interest rate.
Loan-to-Value (LTV) Ratio
The LTV ratio measures the value of the loan against that of the property. Lenders use it to determine how much money they can lend.
Commercial real estate lenders prefer an LTV of around 75 – 80%. However, according to the National Association of Realtors® (NAR), only 60% use it as a criterion for determining how much a business can borrow.
Borrowers with less LTV have a good chance at qualifying for better interest rates than those with higher LTVs. Another point to note is that there are neither VA nor FHA programs nor private mortgage insurance in commercial lending. In the absence of insurance, the lenders depend on the property in case the borrower defaults.
Debt-Service Coverage Ratio (DSCR)
A DSCR compares a property’s annual net operating income (NOI) with the annual mortgage debt service (including principal and interest). NOI is a company’s revenue minus certain operating expenses (COE), not including taxes and interest payments. The ratio helps the lenders determine the loan size based on the cash flow generated by the property.
- DSCR = NOI of Property ÷ Debt Service
- NOI = Revenue − COE
A lower DSCR is adequate for loans with a stable income or a shorter amortization period. However, for businesses with volatile income, lenders may require a higher ratio.
Types of Commercial Real Estate Loans
Commercial real estate lending is a broad topic; there are many financial structures offering loans. This structure attracts buyers with favorable terms and deals. There is practically a loan for every situation you find yourself in.
Nonetheless, these are the most popular types of commercial real estate loans:
A permanent loan is similar to a traditional mortgage. It is also the first loan acquired on a commercial property.
While you can obtain a loan from any commercial lender, they are not open for short-term needs. They come with a repayment term of 5 years or more and an amortization schedule.
- SBA 7(a) Loans: SBA 7(a) loans are provided by a single private commercial lender and have a lot of flexibility. Up to 85% of the loan is guaranteed by the SBA, which you can use to provide working capital and purchase inventory.
- SBA 504 Loans: SBA 504 loans are offered through two lenders: a private commercial lender (50% of the project costs) and a certified development company (40% of the project costs). You may need to provide 10% as the down payment.
A Key Point to Remember: Real estate investors are not eligible for an SBA loan.
Bridge loans are short-term loans with terms ranging from 6 months to 3 years. Small business owners waiting for long-term financing use this in the interim period. They can also be used by real estate investors looking to buy and flip investment property for short-term gains.
Hard Money Loans
Hard money loans are strictly short-term financing offered only by private companies and individuals but not your bank. The value of the property guarantees them. The term lasts between 3 months and three years because investors do not hold on to the property for long.
Owner financing allows home buyers or real estate investors to purchase a home and pay the seller directly without availing of a mortgage. They are helpful if your credit score is low or you have a hard time verifying your income. They are also a welcome alternative when traditional lenders would not work with you.
How Much Will My Bank Lend for Commercial Property?
The amount that a bank lends depends on your contribution. For example, most financial institutions require a 30% down payment for a commercial real estate loan. In other words, your lender will consider lending you 70% of the property’s value.
Investing in real estate is one of the efficient ways to financial independence. It offers incredible returns and better tax breaks. In addition, real estate investors often look at commercial lending quite favorably since they give more control over the value of the assets.
Commercial real estate loans provide an excellent platform for small business owners to establish their own businesses. However, with so many loans available, you may want to shop around for suitable financial options and lenders for your needs.
Compare each loan, the terms, and the repayment period firsthand. Also, look at the fine print for the prepayment penalty (if any). Taking time to look around can help you find the right loan for your business.