Are you looking to build, renovate or buy space for your business? Whether you need property for a store, office or factory, you’ll need a funding plan that makes sense in the long-run. With so many commercial real estate lenders offering different types of loans, it can be difficult to navigate your available options.
We’re here to help! Below you’ll find a simple breakdown of Commercial Real Estate Financing. You’ll learn about Who is offering What loans—and most importantly, at What Cost?
What is Commercial Real Estate Financing?
Commercial Real Estate Financing is the process of taking a loan for the purchase, renovation or development of property that will be used for business operations.
Commercial real estate loans serve a wide variety of businesses—ranging from start-ups to large corporations—so you can imagine how they can vary in cost and structure. The best loan for your needs will depend on your business’s size, revenue, years in operation, creditworthiness and other measures that we’ll explore below.
Types of Commercial Real Estate Loans
First things first… are you a business? While we’ll delve deeper into specific requirements below, you should know one thing before reading further: In order to apply for a commercial real estate loan, you must be a business entity, such as an LLC or S-Corporation. You cannot apply as an individual, nor should you approach a commercial real estate loan as you would a residential mortgage.
You should also know that commercial real estate loans generally have shorter repayment periods, ranging from 6 months to 20 years. This is in contrast to the 30-year terms you’ll find with most residential mortgages.
To grasp the fundamentals of commercial real estate financing, you should first learn about the different types of loans and lenders.
Conventional commercial real estate mortgages are offered by banks to businesses with strong financials. If you’re an established business with several years of consistent revenue and a good credit score, this is the type you should pursue. A bank loan will likely offer the longest terms with the most reasonable rates—and may not require the owner to occupy the property.
The Small Business Administration offers their SBA 7(a) and SBA 504 loans to companies who’ve been rejected by traditional banks. While the money is provided by banks, credit unions, private lenders, and community development corporations, the government backs these mortgages. Therefore, lenders can accept some risk without charging exorbitant rates. Note that SBA loans require that the business owner occupies at least 51% of the property.
Hard Money Loans are offered by private investors who are a bit laxer on underwriting in exchange for higher interest rates. These loans are typically shorter in nature, ranging from 6 months to 2 years. These are great for fixer-uppers where both the borrowing business and lender (or investor) see an opportunity for quick profit.
Bridge Loans are also meant for short periods and have a fast approval process. However, they have higher credit standards than hard money loans, which means they can offer lower rates. As the name implies, they’re meant to bridge the funding gap when waiting for longer-term financing or the collection of anticipated revenue.
If the loans mentioned above don’t work for you, other choices include online marketplace loans, peer-to-peer funding and joint venture loans. Bottom line: You have options!
Why Use Commercial Real Estate Financing?
More physical space can help your business thrive and grow. No question about it! And unless you’re sitting on a large stockpile of cash, you should pursue some form of commercial real estate financing to avoid cash flow problems.
Different options to suit your needs
Variety of term lengths
Build equity in potentially valuable real estate
Preserve cash flow
Strict qualifications for the best rates
Lengthy application process (although not always)
Potentially high down payments
May require large balloon payments at end of term
May require owner to occupy the purchased property
Commercial Real Estate Financing Rates, Cost and Terms
Interest rates on commercial real estate loans are, on average, higher than those of residential loans. Given the variety of businesses and lenders involved, they fall in a very wide range. Conventional loans offered by banks offer rates in the range of 4.5-7%, while SBA loan rates may dip even lower. With Bridge Loans, expect 6-9%, but for other short-term loans that are less strict about credit scores, rates can rise quite dramatically. Hard loans, for example, begin around 10% and can go as high as 18%. You’ll find similar ranges with nontraditional lenders (online, peer-to-peer, etc.), offering alternatives to those with less-than-stellar credit scores.
Don’t be surprised by additional fees to cover appraisals, surveys, legal costs, loan application, and other expenses tied to the loan.
Commercial real estate financing is typically offered either as an intermediate-term loan lasting 3 years or less (usually hard money or bridge loans)—or as a long-term loan lasting somewhere between 5 and 20 years. Unlike with residential mortgage loans, lenders won’t extend it much longer than that. This makes sense, given the volatile nature of business cycles.
Commercial real estate loans come in two general forms: amortized loans and balloon loans. Amortized loans require fixed payments of principal and interest spread out evenly over the course of the term.
Balloon loans have shorter terms of around 5-7 years. They begin with amortized payments as if it’s a 20-30 year term, but require one big “balloon” payment at the end of the 5-7 years. This kind of loan is, of course, risky for the borrower and should only be used if you’re confident you’ll have the funds to make that giant payment.
Speed of Funding
If you’re looking for speed, hard money or alternative online loans are your best bet. With these short-term loan options, you can get financing within 2 weeks. Expect conventional and SBA loan applications to take longer, as lenders will practice extreme due diligence to lower their risk.
How to Qualify for Commercial Real Estate Financing
To be considered for a conventional loan from a bank, you should have a credit score above 700. For SBA and bridge loans, your score should be around 650 or above. Hard money and alternative loans will be more forgiving, but your rates will be higher with possibly shorter repayment terms.
Speaking of early repayment, different lenders have varying policies. Most lenders count on long-term interest as expected income, and therefore discourage repayment with penalties. This, however, is not always the case, so make sure to discuss this with your lender before agreeing to a loan.
In the previous section, we gave you general ranges of interest rates, according to loan type. But how do lenders settle on a rate within those ranges?
When you apply for commercial real estate financing, lenders will use several metrics to evaluate your business and the property you plan to purchase. You’ll need to submit several documents showing:
- Financial records and reports (up to 5 years)
- Business certification
- Tax returns (up to 5 years)
- Projected cash flows (for duration of loan)
- Third-party appraisal of property
- Detailed plan about how property will be utilized
This list is not meant to be exhaustive, as traditional banks could require more documentation, while hard money and alternative lenders may require less.
After assessing your business and the property value, the lender can determine how big of a loan to offer. Minimum loan amounts begin at around $50,000, while maximum amounts will vary by lender and the type of business purchasing the property.
An LTV (loan-to-value) ratio is the loan amount divided by the property value. Depending on your credit score, years in business, and other indicators of financial health, the lender can determine an appropriate LTV, which usually ranges between 65%-85%.
Commercial real estate loans also require a down payment. This not only covers the remainder of the property’s purchase amount (after LTV), but mitigates some risk to the lender, seeing that the borrower is invested in the property.
Let’s imagine you want to buy a commercial property worth $500,000. With good credit and several years in business, you might get a loan amount of $400,000, which is an LTV ratio of 80%. You would then have to make a 20% down payment, which in this case is $100,000.
Most lenders also like to check a business’s DSCR (debt-service coverage ratio) before determining interest rates and maximum loan amount. You can calculate your DSCR by dividing your annual net operating income (NOI) by your total annual debt payments. Anything above a 1 indicates positive cash flow. However, lenders will likely want to see a DSCR of at least 1.25 (the higher the better) to offer you a substantial loan with reasonable rates.
Another way that lenders mitigate risk is through liens. When a lien is put on a property, lenders have the legal right to seize that property if the owner (debtor) cannot repay the loan. In other words, a commercial real estate loan is secured by the purchased property as collateral. Some lenders will demand a personal guarantee of payment on the loan. This would hold the individual principals or owners of the business responsible for paying off the loan should the business entity default.
Questions about which commercial real estate loan is right for your business? Contact Us. Together, we’ll find a customized solution for your needs.