Commercial Real Estate LoansCASAPLORERTrusted & Transparent
Just as homeowners take out residential loans, or mortgages, to finance the purchase of their homes, business owners who want to purchase, expand or renovate a commercial property can take out a commercial real estate loan. Commercial real estate loans are normally used for properties that generate income.
What You Should Know
- Commercial real estate loans are used to purchase, expand or renovate income-generating properties
- Compared to residential loans, commercial real estate loans have stricter financial requirements
- There are different types of commercial real estate loans: permanent, SBA, conduit, bridge loans, hard money loans, and soft money loans
- Depending on the life and credit history of the business, commercial real estate lenders can look at the creditworthiness of the business and its owners
What is a Commercial Real Estate Loan?
A commercial real estate loan is a loan used to purchase, expand or make renovations on properties that are used to generate income. These properties can include:
- Shopping malls
- Office buildings
- Apartment complexes
Banks and lenders offer commercial real estate loans to businesses that are incapable of financing these major investments on their own. Much like a regular mortgage, commercial real estate loans have requirements based on the borrowers’ creditworthiness on which they determine the amount of loan, the interest rate, and other terms.
What do Commercial Real Estate Lenders Look For?
When assessing the creditworthiness of the borrower, commercial real estate lenders look at the finances of the business, the personal finances of the owners or principles, and the value of the collateral.
Creditworthiness of Business
Giving out loans to small businesses can be riskier for lenders because there is a higher probability of default. In order to ensure the creditworthiness of the business, commercial real estate lenders will want to look at statements that present the financial standing of the business and the business’s credit history. These can include tax returns, financial books, and reports, bank statements, etc.
Lenders want to make sure that the business has enough cash flows to cover the costs of taking out a commercial real estate loan. The Debt-Service Coverage ratio is usually used to measure how capable the business is to repay the loan. The DSCR measures how much of the debt service can be covered with the Net Operating Income the business generates.It is calculated as Net Operating Income over the total debt service. Commercial real estate lenders typically look for a DSCR ratio of 1.25.
If the business has had some credit activity in the past, lenders will typically look at the FICO SBSS (Small Business Scoring Service) score. A higher score means that the business has been able to pay its financial obligations in the past and thus contributes positively to the chances of getting approved for a commercial loan. Some commercial loans have minimum FICO SBSS credit score requirements.
Creditworthiness of Owners
To take out a commercial real estate loan, the owners of the business entity might have to guarantee the loan in the case where the entity does not have sufficient financial records or credit history for the lender to assess its creditworthiness. This means that the owners will be held accountable if the business defaults on the loan.
Just as in a residential real estate loan, where the lender checks if you have gone bankrupt in the past or if there are any financial liens on your property, the same process happens when applying for a commercial real estate loan. Since the owners are closely tied to the business, the owners’ personal financial standing may improve or decrease the business’s chances of getting a commercial real estate loan.
The property will typically act as collateral that is taken by the lender if the business fails to make the payments and ultimately defaults on its loan. One of the requirements to be approved for a commercial real estate loan is that the small business has to occupy at least 51% of the property. The business’s creditworthiness and the value of the property will be some of the deciding factors of whether the entity is approved of its commercial real estate loan.
Commercial Real Estate Loan vs Residential Loan
Even though commercial real estate loans and residential loans are taken for different purposes, they are very similar to one another in terms of what the lenders look at when deciding to approve your application. Below we will discuss how these requirements differ for the two types of loans:
|Interest rates||Higher interest rates than residential loans||Lower interest rates than commercial loans|
|LTV||65% - 80%||Up to 97% for conventional mortgages and 96.5% - 100% for non-conventional mortgages|
|Repayment Schedule||5 years or less - 20 years||15 - 30 year mortgages|
|Private Mortgage Insurance||Not required||Required for conventional loans with a down payment 20%|
|Guaranteed by||Business entity or owners||Owners|
The LTV ratio is used to measure how much of the value of the property is financed through the loan. Loans with lower LTV ratios are less risky since a smaller portion of the value of the property is financed through the loan.This takes into account the down payment that the borrower makes. The higher the down payment, the lower the LTV ratio.
Lenders of residential real estate loans generally accept higher LTV ratios than commercial real estate lenders. You can qualify for some conventional mortgages even with a 97% LTV ratio.Government-insured mortgages such as VA and USDA loans can also accept an LTV ratio of 100%, meaning that you would not have to put anything down. FHA loans, on the other hand, accept an LTV ratio of 96.5% for individuals who fulfill other requirements.
Meanwhile, commercial real estate lenders look for LTV ratios between 65% to 80%.The specific LTV ratio requirement will depend on the type of commercial real estate loan you are applying for, the type of property involved, and on the fulfillment of other requirements that ensure creditworthiness. It is worth mentioning that VA and FHA loans are not offered for commercial real estate.
Debt-Service Coverage Ratio
As mentioned earlier, the Debt-Service Coverage ratio is one of the financial ratios that the lenders of commercial real estate will look at when evaluating the loan application. Lenders typically look for a DSCR ratio of at least 1.25. This ratio is not applicable to residential home loans. Instead, residential real estate borrowers are evaluated on their debt-to-income ratio.
Debt-Service Coverage Ratio - Formula
DSCR = Net Operating Income/ Debt Service
A business is looking to borrow $200,000 through a commercial real estate loan. How much would the Net Operating Income of the business have to be in order to meet the DSCR requirement?
Debt Service = $200,000
DSCR Required = 1.25
Net Operating Income = Debt Service * DSCR
= $200,000 * 1.25
The net operating income of the business needs to be at least $250,000.
Commercial loan applications may be approved even with a lower DSCR than 1.25 when the amortization period is shorter or when the business proves to have very stable cash flows throughout the year. On the contrary, businesses with fluctuating cash flows may be required to have a higher DSCR to be approved since, during periods of low activity, the business may not be able to cover the loan payments.
Interest Rates and Fees
Commercial real estate loans generally have higher interest rates than residential loans. The interest rates can range from 2% for SBA loans to 18% for hard money loans. The costs associated with taking out a commercial loan are usually higher as well. These costs can include:
- Loan origination fees → Usually 0.5% - 1% of the loan amount
- Loan application fees → Can range between $500 to as high as $200,000
- Appraisal fees → $2,000 - $3,000 depending on property size and state
- Building inspection report → $500 - $5,000 depending on property size and state
- Legal costs
The business might be required to pay some fees directly upfront, some annually, or in a combination of a smaller upfront fee and annual payments.
Loan Repayment Schedule
Commercial real estate loans typically have terms of 5 years or less to 20 years. The amortization period of these loans is usually longer. This means that at the end of the term of a commercial loan, the business either has to refinance the loan or make a balloon payment to cover the remaining balance. Residential properties on the other hand have terms of 15 to 30 years, with the most popular product being the 30-year fixed-rate mortgage. Similar to residential loans, longer-term commercial real estate loans typically have higher interest rates.
Private Mortgage Insurance
While residential lenders shift some of the risks to insurance companies by charging private mortgage insurance premiums to borrowers who put less than a 20% down payment, commercial real estate lenders tend to keep the risk on their own. This means there is no private mortgage insurance for commercial real estate loans.
Types of Commercial Real Estate Loans
A permanent commercial real estate loan is the first loan you take for a commercial property. These loans are very similar to residential loans and are offered widely by most commercial lenders. Permanent loans are usually given out for long-term needs, which is why they typically have terms of at least 5 years and amortization periods of 25 years.
SBA real estate loans are the commercial loans that are guaranteed by the U.S. Small Business Administration. When getting an SBA loan, you may be required to pay a guarantee fee of 3.75% of the portion of the loan that the SBA guarantees. There are two types of SBA loan programs that businesses can use depending on their needs.
SBA 7(a) loans
This is SBA’s most popular loan program. SBA 7(a) commercial loans can be used for a variety of needs, from financing the purchase of real estate to purchasing inventory or working capital. The SBA 7(a) loans are only offered by SBA authorized or “preferred” private lenders, such as Wells Fargo Bank, U.S. Bank, and JPMorgan Chase. SBA can guarantee around 85% of the loan if the amount is up to $150,000 and only 75% if the amount exceeds $150,000. The maximum amount a business can borrow through an SBA 7(a) loan is $5 Million and the down payment required starts from 10%.
SBA 7(a) loans come in fixed and variable interest rates. Only some rates, such as the Prime Rate, are accepted as a base rate for variable interest rates. The spread between this base rate and the variable interest rate decided is capped. For loans with a maturity of fewer than 7 years, the spread cannot be larger than 2.25%. On the other hand, for loans with a maturity of more than 7 years, the interest rate spread is capped at 2.75%.
SBA 504 loan
This loan program is intended for businesses that want to purchase, construct or renovate major fixed assets. Contrary to SBA 7(a) loans that are financed by private lenders, some of the financing of an SBA 504 loan is provided by Certified Development Companies (CDC), which are regulated by SBA. Typically, the private lender will finance 50% of the project and a CDC will cover 40%. The leftover 10% will be the down payment.
SBA 504 loans are fixed-rate loans with 10-, 20- and 25-years maturity terms available. The maximum amount that can be borrowed is $5 Million. Lastly, to qualify for an SBA 504 loan the business needs to meet some criteria that categorize it as a “small” business. For example, the business would have to prove that its tangible net worth is less than $5 Million and its net income after federal taxes for the 2 years preceding the application has been less than $5 Million.
Bridge loans are commercial real estate loans generally used for short-term purposes. They are called ‘bridge’ loans as they are used to bridge the gap when the business owner is looking for long-term financing. The lack of funds until then can be covered by a bridge loan.Businesses that plan to refinance their existing loan can also use bridge loans.
The term of a bridge loan ranges usually from 6 months to 3 years. These shorter terms present a higher risk to lenders, and so they will charge a higher interest rate for bridge loans and put stricter financial requirements to qualify. The down payment required for a bridge loan is typically between 10% and 20% of the loan amount.
Hard Money Loans
Hard money loans are similar to bridge loans. The main difference is that hard money loans are not offered by banks but by individuals or companies. For private lenders of hard money loans, the value of the property is more important than the creditworthiness of the borrower. Therefore, it is easier to qualify for this type of loan. These lenders do not mind the risk that comes with not thoroughly checking the borrowers’ creditworthiness because they might gain higher profits by selling the property if the borrower defaults.
Hard money loans usually have a term of 6 months to 3 years and come at higher interest rates than other commercial real estate loans. In 2020, the interest rate averaged 11.25%.Moreover, the LTV ratio required is usually 50% - 70% of the loan amount, which is relatively lower than what other commercial real estate loans require.
Soft Money Loans
Soft money loans share some characteristics of hard money loans and traditional mortgages. Just like hard money loans, they are offered by private lenders, and are typically short-term and close faster. However, soft money lenders are not as concerned with the property value as they are with the borrower’s creditworthiness. A higher credit score would probably get you more favorable terms with a soft money loan than a hard money loan. Also, interest rates for soft-money loans tend to be lower.
A conduit or CMBS loan is a form of a securitized commercial mortgage. This means that similar commercial mortgages are pooled together and are sold to investors in the secondary market. These loans are used only for income-generating properties and cannot be used for land or construction of a property. Conduit loans offer a number of benefits to borrowers that would normally not qualify for other commercial real estate loans.
First, conduit loans are usually non-recourse loans. Non-recourse loans are loans that do not have to be guaranteed by the business owners. As we mentioned in the beginning the lenders may look into the business owners’ personal finances who guarantee the loan when the business doesn’t have sufficient financial track record. Secondly, conduit loans have fixed interest rates, which are typically lower than traditional mortgages.
They come in amortization periods of 15-, 20- and 30-years and can fund up to $50 Million worth of investment. One drawback is that CMBS loans usually have prepayment penalties, which means that if you want to pay off the balance beforehand, you will be charged a fee to do so.
When lenders give out loans, they expect to make a certain yield on their investment. This yield is calculated based on the interest payments that the borrower will have to make. Therefore, if after a period of time, borrowers want to prepay the remaining balance of the loan before the end of the loan’s term, lenders end up losing the future interest payments borrowers would have made on the loan and earn a lower yield on the total investment. To compensate for this loss of yield, lenders put prepayment penalties in the loan contract. Prepayment penalties are fees that the borrower has to pay if they want to retire the loan. There are 4 main types of prepayment penalties:
Prepayment penalty - This is the most basic type of penalty. Basically, the penalty requires you to pay a percentage of the loan’s outstanding balance if you want to pay the loan before the end of its term.
Interest Guarantee - Lenders may incorporate a prepayment penalty of a number of interest payments that borrowers would normally have to make if they were not to prepay the loan. For example, the prepayment penalty can be 40 interest payments and a 3% charge on the remaining balance of the loan.
Lockout Period - The lender may specify a period of time during which the borrower is not allowed to prepay the remaining balance of the loan. Only after the lockout period can the borrower prepay the loan.
Defeasance - This is a unique type of prepayment penalty where an exchange of collateral takes place. In this scenario, borrowers exchange a portfolio of U.S. Treasury securities for the initial collateral. The securities must generate enough cash flows to cover the remaining loan balance and interest owed.
Commercial Real Estate Loan Requirements
Requirements for a commercial real estate loan will vary depending on the type of commercial mortgage you are applying for and the lender that is offering it. However, most of the lenders look for the following:
Down Payment: Generally, a 20% down payment is required by commercial real estate lenders. However, depending on the specifics of the loan application, the down payment can be much higher. SBA loans are the exception that requires a down payment of at least 10%.
DSCR: A debt-to-service ratio of 1.25 is usually required. However, it can vary depending on the stability of the business’s cash flows and the term of the loan.
LTV: The loan-to-value ratio required ranges from 65% to 80%. However, loans such as hard money loans can require an LTV as low as 50%.
Other requirements exist for some types of loans such as SBA loans. These loans require you to prove that your business qualifies as a ‘small’ business. To verify this, lenders may ask you to prove that your tangible net worth is less than $5 Million.