Get to know Commercial Real Estate Loans
If you’re seeking small business loans specifically for purchasing commercial real estate, whether that’s a multi-family unit you plan on leasing out or commercial office buildings, there are commercial real estate loans to consider. Let’s dive deeper.
Susan Guillory • February 2, 2021
What are Commercial Real Estate Loans?
Commercial real estate loans are designed to help borrowers purchase new commercial property, renovate income-producing properties, or refinance real estate debt on a property they already own.
The Purpose of a Commercial Real Estate Loan
Real estate is expensive. Commercial property loans allow individuals to purchase property that they otherwise couldn’t afford. These properties are used for business purposes, like office buildings or multifamily properties. The units on these properties can be rented out to tenants to make a profit. Loans open up opportunities for real estate investors and developers to increase the number of viable commercial properties on the market.
How Do Commercial Real Estate Loans Work?
Although commercial real estate loans work similarly to traditional mortgage loans for individuals, there are some key differences that small business owners should understand.
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Loan-to-Value Ratio
The loan-to-value ratio, LTV for short, is a metric that lenders use to determine how much money they can loan. More specifically, they calculate it by dividing the loan amount by the property’s value.
Homebuyers can qualify for a conventional mortgage loan with an LTV as high as 97%, and if you qualify for a first-time homebuyer program or select government-insured loans, you could get up to 100% financing.
With commercial real estate loans, however, lenders typically want an LTV of around 75% to 80%, according to the National Association of Realtors (NAR). This means you either need to purchase an undervalued property or have a 20% to 25% percent down payment before you approach a lender if they are using LTV to determine the loan amount.
That said, the NAR also found that just 60% of commercial real estate lenders used LTV as a criterion for determining how much a business can borrow. The remaining 40% used what’s called the debt service coverage ratio, or DSCR for short.
The DSCR is used to measure the ability of a borrower to pay its current debt obligations with its existing cash flow. To calculate it, you divide your annual net operating income by your total debt payments for the year. According to the NAR, the median DSCR is 1.25.
Personal Guarantee vs. Non-Recourse Loans
Whether you get a mortgage or a commercial real estate loan, the lender will use the property as collateral for the debt. But in some cases, it may also require a personal guarantee.
Depending on how long you’ve been in business, your company may not have the financial track record required by the lender to qualify for a commercial real estate loan. In this scenario, the lender may ask the principals or owners to guarantee the loan. This means that if your business can’t repay the debt, you as the borrower agree to be personally liable for making the monthly payments, in the event that the property itself doesn’t fully cover the amount you still owe.
In another scenario, the lender may not require a personal guarantee and simply use the property itself as the only means to recover the loan funds should you be unable to keep up with your mortgage payments. This is sometimes called a non-recourse loan because the lender cannot get additional money from the business principals or owners if the property doesn’t fully cover the amount owed.
Types of Commercial Real Estate Loans
Depending on the needs of your business and its qualifications, there are six primary types of commercial lending that you can use to achieve your goals:
- Permanent loans
- SBA loans
- Bridge loans
- Lines of credit
- Hard money loans
- Owner financing
You can find a variety of lenders for each type of loan, from commercial banks to credit unions to lenders specializing in commercial real estate loans.
Permanent Loans
A permanent loan is the first loan on a commercial property, similar to a traditional mortgage loan.
You can typically get a permanent loan from any commercial lender, but they’re not available for short-term financing needs—they typically have an amortization schedule and a repayment term of five years or more.
SBA Loans
The U.S. Small Business Administration provides guarantees for some commercial real estate loans, and these loans are often called SBA real estate loans. There are two loan programs under which you can get commercial real estate financing: SBA 7(a) loans and SBA 504 loans. Real estate investors are not eligible for these loans.
- SBA 7(a) Loans
The SBA 7(a) loan program is more general in nature, and business owners have a lot of flexibility in how they can use the funds. The loan is even available for non-real estate financing needs, including purchasing inventory and providing working capital.
Also, SBA 7(a) loans are provided through a single private commercial lender, and up to 85% of the loan amount is guaranteed by the SBA. Down payment requirements start at 10% but can be much higher depending on the lender and the circumstance.
SBA 504 Loans
With the SBA 504 program, small business owners must use the funds to finance the purchase of commercial real estate or machinery and equipment, renovate an existing commercial property, or refinance an eligible commercial real estate or construction loan.
Also, SBA 504 loans are provided through two lenders: a private commercial lender, which provides 50% of the project costs, and a certified development company (CDC), which provides 40%, all of which is guaranteed by the SBA. You provide the remaining 10% as a down payment, though some situations may require more than that amount.
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Bridge Loans
Bridge loans are short-term commercial real estate loans, with repayment terms ranging from six months to three years. Commercial bridge loans are typically used by small business owners who are waiting to apply for long-term financing or to a refinance loan.
However, they can also be used by real estate investors who are looking to fix and flip an investment property for short-term gains.
Lines of Credit
If you’re familiar with personal or business credit cards, you know how a line of credit works. Rather than getting all money you’re borrowing at once, you have access to it, up to a cap. Borrow a little and pay it back, and that full line is available again. This is a good option if you’re renovating a commercial property and need some cash now and more later.
Hard Money Loans
Hard money loans (also known as bridge loans) are a financing solution typically used by real estate investors. These loans are not issued by traditional lenders like banks, but by private companies and individuals. Hard money loans are a form of short-term financing, with the loan term lasting between three and 36 months, because investors don’t intend to hold on to the property for a long time.
Owner Financing
Owner financing allows homebuyers—mostly real estate investors, but anyone can use it—to purchase a home and pay the seller directly instead of getting a mortgage loan. This arrangement can provide the buyer with less strict eligibility requirements.
For example, if your personal or business credit scores are relatively low, you’re self-employed, or you’re having a hard time verifying your income, owner financing could be an alternative where traditional mortgage lenders won’t work with you.
For the owner, the primary benefit is getting a steady stream of income (with interest attached) until the property is paid for in full.
What You Need to Know About Commercial Real Estate Loans
While commercial real estate loans are a great financial solution for many business owners, there are drawbacks to be aware of.
Pros of Commercial Real Estate Loans
Pros
- Many options available
- Variety of terms
- Flexible repayment terms
- Tax breaks
- Equity
Commercial real estate loans offer more diversity and more options than a personal real estate loan or mortgage may afford. This includes repayment terms, interest rates, and payment schedules that can work with your business’ schedule and budget. You’ll also enjoy the tax breaks that come with property ownership, and building equity can add value to your business as you continue making on-time payments.
There are also many property types you can purchase with a commercial real estate loan, including multi-family apartments, retail space, office space, and single-family homes.
Cons of Commercial Real Estate Loans
Cons
- High barrier to entry
- Long approval time
- Riskier to lenders
- High upfront cost
- Loss of capital
There are, unfortunately, a number of drawbacks when it comes to commercial real estate loans. The first comes right at the start; they are quite difficult to qualify for and take a significant amount of time to be approved. You’ll need excellent credit to qualify for the best rates.
Because of economic fluctuations, they are also viewed as being riskier by lenders, which may lead to unfavorable terms depending on the economic climate and your financials.
Just like buying a home, buying commercial real estate also comes at a high upfront cost and loss of liquidity, and possibly even a future loss of capital if your terms include a concluding balloon payment.
What Does it Take to Qualify for a Commercial Real Estate Loan?
Every lender has its own criteria for commercial real estate loans, but there are some important questions to consider before you apply. For example, how much is a down payment on commercial property? And what are the business financial requirements? Do you have the credit scores to support a low interest rate?
As for business financials, what you’ll need depends on the lender. For example, SBA 504 loans actually have a cap: your business’ tangible net worth cannot exceed $15 million, and average net income cannot exceed $5 million after taxes for the prior two years.
With commercial lenders, you may be required to meet certain minimums, such as having at least two years in business under the current ownership and $250,000 in annual revenue.
As you shop around and compare lenders, take note of their requirements to determine whether you qualify. Also, consider both traditional commercial lenders like banks and online lenders in your search. While online lenders may charge higher interest rates, they can also have less stringent requirements for credit approval.
How Much Do You Have to Put Down on a Commercial Real Estate Loan?
You can generally expect to put down a minimum of 20% on most commercial real estate loans (the exception being SBA loans, which start at 10%). Depending on the lender, the situation, and your business’ financials, though, you may be required to put down much more.
Also, keep in mind that a higher down payment means a lower monthly payment going and lower interest costs going forward.
Commercial Real Estate Loan Repayment Schedules
With a commercial mortgage loan, there are plenty of repayment plans you can choose from, but the most common is the 30-year, fixed-rate mortgage loan. With commercial real estate loans, however, repayment terms typically range from five to 20 years, and some commercial loan types provide short-term financing where payment is due within a year.
Also, it’s less common with commercial real estate loans for the amortization schedule to match up with the repayment term. For example, you may get the option for five, 10, or 15 years to pay back your debt, but the amortization schedule goes as high as 25 years.
In this situation, the commercial loan is not designed to be paid in full by the time you complete your repayment term, and your business will need to make a balloon payment at the end to satisfy the remaining balance. If you don’t have the cash required to make the balloon payment, you’ll need to have another commercial real estate loan ready to refinance the remaining debt.
Of course, there are some lenders that offer full amortization, but you’ll need to specifically search for that feature when you’re shopping around.
It’s also important to note that commercial real estate loans typically don’t allow you to pay off your loan early without some kind of fee or penalty. Here are some potential ones you can come across:
- Prepayment penalty
This is typically a percentage of the balance the lender is still owed at the point in the amortization schedule when you pay off the debt early. - Interest guarantee
With this clause, the lender is entitled to a certain amount of interest regardless of when you pay off the debt. For example, a loan may have a guarantee for 10% interest for the first five years, then a 5% prepayment penalty after that. - Lockout
With this clause, the borrower is prohibited from paying off the debt early. A common lockout term is five years.
Defeasance
This process allows small business owners to effectively get out of a real estate loan by providing U.S. Treasury-backed securities as a substitution for the loan’s collateral. To qualify, the securities must generate enough income to cover the remaining principal and interest on the loan. Even so, there may be penalties associated with defeasance.
Interest Rates and Fees for Commercial Real Estate Loans
Commercial real estate loans typically have higher interest rates than mortgage loans, with an average rate of 5 to 11% (as of this writing). Some lenders may go lower than that range, however, depending on the loan type and structure and the financials of the business. For small businesses that qualify, for example, SBA 504 loans typically provide lower commercial real estate loan rates, with averages below 3%.
You can also expect to pay some closing costs, including appraisal fees, origination fees, legal and loan application fees, and more. These fees typically amount to 1% to 2% of the commercial loan amount, which is much lower than what you’d expect with a residential loan. If you’re getting an SBA loan, though, you can also expect to pay a guaranty fee, which can be as high as 3.75% of the guaranteed portion of the loan on its own.
Where a commercial real estate loan can get really costly is with prepayment penalties and fees. As you compare lenders, make sure to read the fine print to determine how much you might be charged if you choose to pay off your debt early.
That said, commercial real estate loans don’t require private mortgage insurance like conventional mortgage loans, so you won’t have to worry about this ongoing cost.
Residential Loans vs. Commercial Real Estate Loans
If you’re curious about the differences between a mortgage loan and a commercial real estate loan, it can help to look at a quick breakdown. Commercial loans have several features that residential loans don’t have, like:
- Higher interest rates
- Lower closing costs
- Prepayment penalties
- Interest guarantee
- Repayment terms of five to 20 years
- Higher minimum down payment
Residential loans and commercial loans are designed to be used for different property types and purposes, so they aren’t interchangeable.
How to Get a Commercial Real Estate Loan
Each type of commercial loan will have a slightly different process for applying and getting approved. Spend time looking at requirements to make sure you have all the necessary paperwork to strengthen your application.
How to Prepare for a Commercial Real Estate Loan
Once you’ve reviewed the requirements for the loan you’re planning to apply for, spend some time gathering everything you’ll need in advance of applying. The more prepared you are, the easier the application process will go.
If you know your credit scores won’t qualify you for the best rates, you might consider building your credit before applying. You can do this by paying down other debt, making your loan payments on time, and monitoring your credit report regularly.
Also, before applying, get a plan for how you will be able to pay the loan back. If you take on too much debt and aren’t able to make your monthly payments, the real estate you’re buying could be seized by the bank or lender.
How to Find the Right Commercial Real Estate Loan for You
Consider all the factors of the loan you’re looking into — from the repayment terms to the fees to the type of loan — before applying. The best loan for you fits with your needs, gives you enough funding, and is manageable financially for your small business. Before entering into any contract, make sure you understand the fine print and what the total cost will be over the life of the loan.
PHILILOAN Verdict: Commercial Real Estate Loans
Commercial real estate loans can provide a great way for small business owners to build or expand their businesses. With so many financial solutions and terms to think about, though, be sure to take your time to find the right loan type and lender for your needs.
Also, consider the right repayment term for your business. A loan with a balloon payment may offer lower monthly payments, but it can cause problems down the road if you can’t make the final payment and can’t refinance the debt.
Finally, when you’re shopping around, take the time to compare each loan based on the full terms, and not just the interest rates and repayment terms. Look at the fine print to find out if there are any penalties for paying off the loan early, and check to see if the lender requires a personal guarantee.There’s no one-size-fits-all loan that works for everyone, but taking the time to carefully compare each available option will give you a better chance of finding the right fit for your business. Phililoan Business Loan Builder plan can help you get set up for the best loan possible.