For many businesses, especially small and medium businesses with limited cash flow, getting a loan is essential to securing commercial real estate. However, if this is your first time getting a commercial real estate loan then you may feel confused and overwhelmed with the options available to you.
The biggest hurdle that you need to overcome is being able to wrap your head around how commercial real estate financing works. If you have purchased a vehicle or a home through a bank, then you are familiar with lending. Unfortunately, many of the concepts of residential real estate lending don’t always translate directly to commercial real estate lending. This is a shock for many who walk into their bank expecting a similar experience as when they purchased their home.
There are also a number of various options available when you need to secure financing for commercial property. Residential mortgages generally follow a basic outline where the bank provides the funds, amortizes the payments over 25 or 30 years, and then you make payments on a regular basis. While some commercial real estate loans may work similarly, there are other options that may or may not suit your unique needs.
With all of that said, there are some important similarities that make commercial mortgages and residential home loans similar. These conditions can vary depending on the type of lender and type of loan you’re looking to secure.
In this article, we will take a closer look at commercial real estate loans, what you can expect when you want to secure a loan and the various types of loans available to you.
Check out our Introduction to Commercial Real Estate Loans
How do you qualify for a commercial real estate loan?
Qualifying for a loan is step one in securing a piece of real estate for your business. This is a pretty obvious step in the lending process. However, the qualification criteria can vary depending on the type of loan you are getting, the size of your business, and the property you are looking to purchase.
First, you’ll need to fill out a loan application. The lender will then want to look at your businesses financials to see the amount of cash flow coming into the businesses, as well as whether your business will be able to support both the loan amount and the payments for the loan. Some loans may require that your business has been operating for a certain number of years before you will qualify. Typically, these lenders are looking for around 3 years of operation at a minimum.
With small businesses and new businesses, lenders may also want to look into your personal finances, which also involves pulling your credit report. A good credit score can be one of the most important factors in getting a commercial real estate loan.
For both personal finances and business finances, debt servicing ratio plays a vital role in getting lending secured on a commercial real estate property. This is the ratio of debt to income. Of course, not all expenses are related to debt. As such, lenders want to see a debt service ratio that still allows for normal expenses like insurance, payroll, and other essentials that go into running a business.
The value of the property and the loan-to-value ratio (LTV) is another thing that lenders will look at when considering a commercial real estate loan. Different types of loans will allow for higher LTV ratios but, in a vast majority of typical cases, the LTV ratio must be 90% or lower. In other words, you aren’t able to get a loan for a property that exceeds the appraised value of the property. This can be a challenge if you’re looking at making improvements to the property or constructing a new building but lenders can have appraisers account for the improvements you are planning to make to the property.
How much does a commercial real estate loan cost?
You may be surprised when you walk into a lender’s office to get a commercial real estate loan that the lending rates are typically higher than what you would typically see from a residential mortgage loan. Interest rates can vary from 5% to 10%, and sometimes even higher. The interest rate will largely depend on the type of loan you’re looking for, along with other factors like business credit score and your own personal creditworthiness.
In addition to the interest rate, there are other costs to consider like closing costs which could range anywhere from 1% to 5% of the total value of the property. Again, this will be based on the type of loan you’re looking for and the additional costs needed to complete the loan like lawyer’s fees.
A downpayment is probably the most significant up-front cost you will face. Some loans allow you to put as little as 5% down on the property, while others will require a much greater downpayment, which can be as high as 35% in some cases.
What kind of loan terms should you expect?
Every loan comes with its own set of fine print that you must read closely before signing on the dotted line. Of course, when in doubt, always consult a lawyer before you put pen to paper to ensure that the terms aren’t so strict as to hamper your business in the future.
The repayment term of the loan is one thing you will want to look closely at as this will directly affect the monthly payment you need to make in order to pay off the loan. Longer-term loans up to 30 years are available for some types of loans. Of course, this means committing to a loan payment for that long which some business owners may be hesitant to do. Other loans have much shorter terms with single year loans being common for certain types of financing. Again, this will all depend on your needs for the loan and why you are seeking out the loan in the first place. A long-term loan with lower payments is not always necessary or appropriate.
With some commercial real estate loan programs, there may also be a prepayment penalty for breaking the loan terms. These can range from 1% to 5% of the loan balance and, in the case of a large loan, may be a significant expense for your business. This is why it’s so important to understand the types of loans available for your business and choose the right one for your needs. Going with the right type of loan for your business is crucial to saving you from unnecessary expenses later down the road that could affect your ability to continue operations.
Some loan types will also stipulate how much of the building must be occupied by the owner. This won’t be much of a concern if you plan on buying a property solely for the use of your business. However, if you’re interested in buying a larger property like a strip mall where other tenants and business may be operating, these owner-occupancy terms become very important and may dictate which loans your business is eligible for.
What types of commercial real estate loans are available?
Commercial mortgage loans
This is one of the more common loan types that many businesses will immediately seek out simply because the lending product is similar to residential mortgages in many ways. You can visit most major lenders for this type of commercial real estate loan which means you can likely walk into your local bank branch and speak to someone you may already be familiar with about getting such a loan. This accessibility makes them among the most popular types of commercial loans.
Since a wide range of lenders offer commercial mortgage loans and they aren’t backed by the government, the terms and rates can vary significantly depending on which lender you visit so it’s important to shop around and consider all of your options.
For a commercial mortgage loan, the lender will likely want to see at least 1 year of business activity and a good credit score above 700. From there, the lender will consider the property and have it appraised to determine the value. Once this has been done, you are able to borrow up to 85% of the property’s value on a 1 to 5-year term.
Lenders that offer these mortgage loans usually have lower rates than some other commercial real estate lending options with rates starting as low as 4.5%. Again, this rate can vary significantly based on the lender and their appetite to take on commercial real estate loans as a part of their lending portfolio. Definitely take the time to compare rates among lenders because, simply by shopping around, you could save 4% or more on your interest rate.
These commercial loans tend to have lower costs overall but they may not be right for your unique needs. Be sure to consider all of your lending options before just walking into your usual bank and asking for a commercial real estate loan.
SBA 7(a) loans
SBA 7(a) sounds more like a fictional vaccine in a science fiction movie than a commercial lending agreement. If you have never had to get a commercial loan before then you may likely be unaware of this very exciting lending option for small and medium businesses.
SBA 7(a) loans have backing from the U.S. Small Business Administration. These loans are used for a wide range of commercial needs including, but not limited to, real estate transactions. The conditions to secure one of these loans can be a little more rigorous than a traditional bank commercial loan but the terms may end up being more favorable for your business.
The LTV ratio is one of the best features of an SBA 7(a) loan as it allows you to go as high as 90% of the property’s value. This means you don’t have to save up as significant of a downpayment as you would with other lending options available on the market.
The repayment term is also longer with an SBA 7(a) loan, offering up to 25 years amortization which means that you can secure lower monthly payments. Of course, that does mean that you will be paying for longer so you should consider whether it’s worth it to be paying this loan for such a long period of time.
The costs of getting SBA loans loan can be a little higher than some other options. One of the reasons for this is because there is an SBA guarantee fee which is like an insurance premium paid to the government for backing the loan. Lenders and non-profits that have partnered with the U.S. Small Business Administration to offer these loans have the security of government backing. Of course, the cost of that security essentially comes from you, the borrower. The SBA guarantee fee can cost as much as 3.75% of the purchase price so you should consider that cost before signing the agreement.
Interest rates also tend to be higher for these loans when compared with some other options. This is largely due to the reduced lending requirements as the loans are backed by the government. The threshold for a credit score is not as high as other loan options and, therefore, the risk to lenders and the loan backers is higher. Due to this, SBA 7(a) loans are seen as the next step for someone who has been declined by a bank where they may be able to secure a lower interest rate and also not be on the hook for the SBA guarantee fee.
CDC / SBA 504 loans
These loans, much like the SBA 7(a) loans, are backed by government institutions to help provide banks a guarantee on their loans and stimulate the economy. However, they are more directly focused on providing funds for commercial real estate which gives them less flexibility and makes them less popular than their big brother, the SBA 7(a) loan.
A CDC / SBA 504 loan appears similar to an SBA 7(a) loan in many ways. You can borrow up to 90% of the value of the property and there are also guarantee fees for this type of loan. The SBA guarantee fee is as high as 3.75% and CDC processing fee can be as much as 1.5% in addition to that. This can obviously make the up-front costs more significant, especially if you’re planning on getting a loan worth hundreds of thousands of dollars.
Interest rates are slightly lower on these loans, ranging from 3.5% to 5%, likely due to the additional fees associated with the loans and the backing from the government to help reduce the risk taken on by lenders. In addition, those payments can be amortized over 20 years to keep monthly or bi-weekly payments low and manageable.
These loans do require a minimum of 3 years in business and usually are geared towards growing businesses so it may not be a viable option for new businesses but it’s definitely something to consider if you operate a small or medium-sized business that’s ready to take that next step in growth.
Commercial hard money loan
The last few loan types have been long term loans for businesses looking to buy properties. But what do you do if you already have real estate and simply want to improve it? A commercial hard money loan may be the answer.
These short-term loans are designed to help businesses renovate or improve existing properties. Think of these loans more like a line of credit you may use to renovate your home rather than the mortgage you used to buy your home.
Much like a line of credit, a commercial hard money loan carries a much higher interest rate that can creep into the double-digit percentages. Clearly, you do not want to hold a balance on one of these loans for very long. 3 years is generally the maximum length of time you can get a hard money loan.
For renovations or improvements, you may borrow up to 80% of the cost of the improvement. You can also borrow up to 90% LTV for a purchase. Generally, businesses use these loans if they have short term plans for the property. A great example would be if a business wanted to renovate the property in anticipation of selling the property or securing a long-term mortgage to help with expansion and growth using the property as security.
Commercial bridge loan
A bridge loan is another short-term loan option for businesses that need financing immediately with intentions of securing more favorable financing in the future. As you may expect, these short-term loans come with higher interest rates up to 10%.
You may consider a commercial bridge loan for your business if you are planning on buying property quickly but may not immediately meet all of the conditions for a long-term loan with lower interest rates right away. Instead of passing up on the opportunity, bride financing can help you get the property while you sort out the other details.
A common example of this is if a business sees a property they want to purchase, but own an existing property and can’t move their operations in time to satisfy the owner-occupancy requirement for a traditional commercial mortgage. Bridge financing gets the deal done while you work out the rest.