COMMERCIAL LOAN GUIDE

A Complete Guide to Commercial Real Estate Loans

September 10, 2020

What is Commercial Real Estate Loans?

What is Commercial Real Estate Loans?

Commercial real estate (CRE) loans refer to loans made to finance the acquisition, construction, and/or development of income-producing commercial properties used solely for business purposes.

Examples of CRE properties include shopping centers, retail spaces, office buildings, hotels, etc. Multifamily homes with five or more units are also considered commercial.

Compared to finding in qualifying for the right commercial real estate loan, getting a residential mortgage is a walk in the park.  But here’s good news: For as long as you’re armed with the right information, you can find the financing you need to invest in a commercial property successfully.

Where can you get commercial real estate loans?

CRE loans are provided by both banks and independent lenders, just as home mortgages. These loans are also available from insurance companies, private investors, pension funds, and other sources such as the Small Business Administration, which offers the 504 loan program specifically for providing SME owners with capital to acquire commercial real estate.

​How do Commercial Real Estate Loans Work?

To understand how CRE loans work, it often makes sense to compare it with residential loans.

Individual Borrowers vs. Entities

Home mortgages are usually granted to individual borrowers, but CRE loans are often made to corporations, limited partnerships, developers, funds and trusts, and other business entities formed specifically to own income-producing commercial properties.

If the entity does not have any credit rating or financial track record, the lender may ask its owners or principals to act as the loan guarantors. Otherwise, the property itself becomes the lender’s only means of recovery should the loan default. This CRE loan is termed a non-recourse loan, which means that the lender has “no recourse” against anything other than commercial property.

Schedule of Loan Repayment

Commercial and residential loans differ in terms of loan repayment schedules.

Residential mortgages are typically repaid over a long period; the 30-year fixed-rate mortgage is the most popular home loan product. Buyers of residential properties have other options, of course, such as 15- and 25-year mortgages. The longer the amortization period, the lower the monthly payments, but the higher the interest costs over the entire term.

Meanwhile, the terms of CRE loans are much shorter, usually ranging from five to 20 years. Additionally, the amortization period is typically longer than the term of the CRE loan.

For example, a lender might provide a seven-year term loan with a 30-year amortization period. Interest rates are affected by the length of the amortization period and the loan term. Terms may be negotiable for borrowers with strong credit. As a general rule, higher interest rates accompany longer loan repayment schedules.

Loan-To-Value Ratios

Commercial and residential loans also differ in terms of loan-to-value or LTV ratios, which refers to measuring a loan’s value against the property’s value. In both types of loans, lower LTV’s qualified for better financing rates compared to higher LTVs. Why?

Because a lower LTV indicates that the borrower has more equity in the property—and for lenders, this means less risk.

Do note that higher LTV’s may be allowed for certain home mortgages. VA and USDA loans, for example, allow up to 100% LTV. Conventional loans are allowed up to 95% LTV.

Not so for commercial real estate. LTVs in CRE loans usually fall in the 65% to 80% range.

Some types of CRE loans allow higher LTVs, but these are rare. The maximum LTV depends on what type of commercial property is being purchased. For raw land, it is typically set at 65%. For multifamily constructions, it’s usually 80%.

Unlike in residential loans, there is no private mortgage insurance in commercial property lending, nor are there FHA or VA programs. This means that CRE lenders have no insurance covering defaults, relying only on the property and pledged as collateral.

Debt Service Coverage Ratio

CRE lenders consider the debt-service coverage ratio or DSCR when evaluating loan applications. The DSCR compares the commercial real estate asset’s yearly net operating income (NOI) and its yearly mortgage debt service. It indicates if the property makes enough money to service the debt.

Most lenders want a DSCR of 1.25 and higher to ensure that the property generates adequate cash flow. A DSCR lower than 1 shows a negative cash flow. A DSCR of 0.92 indicates that the NOI is enough to cover only 92% of yearly debt service.

That said, lenders may accept a lower DSCR for properties that generate stable cash flow and loans with shorter amortization periods. In general, higher ratios are required for CRE assets that tend to have volatile earnings, including hotels that don’t have the security of long-term tenant leases compared to other kinds of commercial properties.

Commercial Real Estate Interest Rates

Commercial loan interest rates are typically higher compared to interest rates on residential loans. Additionally, CRE loan borrowers usually have to shoulder other costs, such as appraisal fees, loan application fees, legal fees, survey fees, and loan origination fees.

Some of these costs have to be paid before the commercial loan is approved. Others can be paid yearly. For example, the loan might have a one-time 1% loan origination fee that has to be paid at closing, plus a 0.25% yearly fee until it is fully paid.

Prepayment

To protect the profit the lender makes from the loan, CRE loans often have prepayment restrictions. Borrowers who want to pay off the debt before the mature ad date will probably have to pay exit penalties.

  • Prepayment penalty – This is determined by multiplying a specified prepayment penalty by the current outstanding balance on loan and the most basic exit penalty type.
  • Interest guarantee – This entitles the lender to a specified interest amount even if the borrower pays off the loan early. Some loans have an 8% interest rate guaranteed for five years, for example, with a 5% prepayment fee after that.
  • Lockout – A loan might have a five-year lockout, and to be during which the borrower is not allowed to pay it off.
  • Defeasance – The borrower can exchange and new collateral (such as U.S. Treasury securities) instead of paying the lender cash. This potentially reduces fees. However, this method of paying off a commercial loan often involves higher penalties.

Prepayment terms are negotiable, to just like other loan terms identified in the commercial real estate loan document.

Also Read: Commercial Real Estate Loan Terminologies

Finding the Right Commercial real estate loan

If you’re interested in investing in CRE properties and are looking for financing, it’s important to steer clear of lenders who might let you down—those that overpromise and underdeliver. Partnering with the right lender is key to a successful deal. Here are some tips to keep in mind:

1. Take Your Time to Explore Your Options.

There is no harm in applying for commercial loans from traditional lenders like banks. But don’t limit yourself to them. There is a whole wide world of alternative lending available for commercial real estate. Exploring it can give you a complete picture of the options available to you so that you can make a more informed decision later on.

Investors in the alternative lending market typically offer better rates and terms than banks. They’re also more flexible when it comes to application requirements; plus, their processing times are faster.

Make sure to cast your net wide, too. Don’t be afraid to look for lenders in other parts of the country—not just your locality. Please don’t believe the myth that it’s safer to borrow money from a lender that is close to you geographically. This is not true.

2. Have a Solid Plan for How You will use the Money.

Having a robust business plan for using the loan proceeds can put you in a better position for negotiating with potential lenders. You will want to show them that you know what you’re doing and that your project makes business sense. Be sure to include a clear time frame in your plan. Lenders want to see exactly when the project will start and end.

3. Make Sure that Your Balance Sheet is Ready.

The last thing you want to happen is to run out of cash once your commercial property is built or purchased. This will push you into a horrible dilemma of either defaulting on the loan while continuing to operate the property or continuing to service the loan while not being able to run the property in a way that truly maximizes the asset’s income-generating potential. It’s always prudent to review your balance sheet way ahead of time to see whether it truly makes sense to borrow money for additional working capital or get a business line of credit in case you need it.

4. Build a Good relationship with the Lender.

Please don’t underestimate how important it is to win the trust of your lender. A CRE loan is a big deal; it’s not like simply buying any product or service for your business. You will be in a long-term relationship with your lender, so you want them to be consistently reliable.

Remember: The best lenders want you to succeed. They do everything they can to help you maximize value and minimize costs even after the deal is sealed.

Applying for a Commercial Real Estate Loan

CRE loans are not just available to investors—they’re also available to small business owners. The latter want to purchase an office, warehouse, or any other commercial real estate asset to occupy it and actively use it. In this case, lenders will usually require you to use at least 51% of the structure (the rest, you can lease out). They will also look at three factors in assessing your commercial loan application: The financial state of your business, your finances, and the characteristics of the property.

The financial state of your business

CRE loans are considered risky, so they often involve more scrutiny compared to residential mortgages. If you’re borrowing from a traditional lender like a bank, expect them to ask for your books to check if your company makes adequate cash flow to repay the loan. Refer back to our discussion of the debt service coverage ratio. If your ratio is 1.25 or higher, you have a better chance of being approved for a CRE loan.

Traditional lenders will also want to look into your business’ credit score to determine what terms to apply for the loan—the interest rate, down payment requirement, and payback period. The typical minimum FICO SBSS credit score required is 140. That said, small businesses with lower scores still manage to get CRE loans if they excel in other criteria.

To be approved for a loan to purchase or renovate a commercial real estate asset, your business should be structured properly, either as an LLC, an LP, or an S or C corporation. Real estate loans made to sole proprietorships are considered ‘personal’ instead of commercial; it’s not a good idea, as it risks your wealth in case of default.

Your finances

If you’re an SME, your company is likely controlled by just one owner (you) or a handful of partners. Traditional commercial loan lenders may want to look at your personal financial history and credit score to see if there are any red flags—such as financial problems like defaults, tax liens, foreclosures, and court judgments—in your past.

Characteristics of the property

In a CRE loan, the property you want to buy or renovate serves as the collateral—it will be seized by the lender should you fail to pay the loan. To get approved for a CRE loan, your business has to occupy at least 51% of the property; otherwise, it’s an investment property loan you should be applying for (appropriate for income-generating commercial rental properties).

Going beyond traditional lenders

Suppose you don’t meet the requirements of banks and other traditional commercial lenders[as per wiki] or don’t have the time to wait for their usually-long application and approval processes. In that case, you can try to get financing from non-bank finance companies and hard-money lenders instead.

These types of lenders are much less concerned about you and your business’ financial standing. Instead, they base loans on the value of the property itself—whether it’s a storefront, a warehouse, or a multifamily property (if you run your company out of it and use at least 51% of the property).

These lenders provide CRE loans for SMEs that need money fast. Their rates tend to be higher than traditional lenders, but their underwriting standards are also less rigid, and approval is faster. Fees and closing costs are also typically lower.

Hard-money lenders usually offer around 65% to 75% of the property’s value, so your business must put up the remainder. For a property appraised at $2,000,000 where the lender requires an LTV of 70%, for example, you need to put down $600,000 to secure a loan of $1,400,000.

Depending on your circumstances, it might make sense to take out these shorter-term loans while waiting to get a traditional loan on the property. Talk to a commercial lending consultant to figure out what’s best for your case.

Get the financing you need

At Capital Investors Direct, we proudly help both small and large CRE investors find the right commercial real estate financing solutions and for their projects. If you’re interested in a commercial loan, contact us for consultation. You can also explore our website for more details on the kinds of CRE financing solutions we offer.

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