Commercial properties tend to higher returns compared to residential properties. They also offer the benefits of longer leases. It’s no surprise that many people are interested in commercial investment properties.
Are you one of them? Do you want to diversify your portfolio to include this asset class but are intimidated by the complexity and risk of financing such projects? You’re not alone. Even sophisticated investors often find it daunting to qualify for commercial investment property loans. The good news is that it’s impossible to get funding if you understand what lenders are looking for.
In this guide, we answer some of the common questions asked by commercial property investors when seeking loans:
What do you need to show a lender when applying for a commercial investment property loan?
Put yourself in issues of a bank or commercial lender and try to imagine what they want. You will quickly realize that their key consideration is whether or not your project can generate income and/or profit that will allow you to pay off the loan as agreed. This is why they ask for the following documentation:
- Details on how the property makes money, including existing leases and the lengths of these lease agreements
- For property without tenants, documents showing how you intend to afford the repayments and maintenance costs
- Your personal income details
- Your business income details
- Any deposits are equities you have in other properties (if any)
- Details about the project itself, including its location, valuation, and asset class
- Your bank statements in the last two months
- Your investment and retirement account statements
- Pay stubs if you are employed and receive a regular pay check
- Your Social Security and driver’s license
- Separation, divorce, or bankruptcy papers (if any)
- Business or occupational license if you’re self-employed
- Your tax returns and business bank and financial statements
How can you increase your chances of approval?
The more you can prove to a bank or a lender that your financial situation has been stable in the last three years or so, the better your chances of qualifying for an investment property loan. Depending on your case, it might also be a good idea to do the following:
1. Consult a mortgage broker.
Mortgage brokers who specialize in commercial real estate loans can advise you on precisely how you can make your application stronger. They also have relationships with different lenders and recommend a suitable lender based on your situation and your project goals. A commercial mortgage broker can likewise walk you through the different loan options and criteria of each potential lender while guiding the latest trends and indicative rates.
If your commercial property project is complex, it might be a good idea to have financial and legal experts working with you, too. They can comb through any contracts and/or lease agreements to ensure that you are protected. For example, a lawyer can review break or termination clauses that allow tenants to and their leases earlier than agreed and let you know about such loopholes. It’s important to get a clear picture of what you’re getting into because there’s far too much risk in a complex commercial real estate deal.
2. Hire a professional property appraiser.
The lender will require a professional appraisal to determine the market value of your project—meaning the value of the commercial structure in the land that accompanies it. This ensures that the lender does not inadvertently loan you more than what the asset is worth. A commercial property’s value is not just affected by the condition of the structure’s plumbing or roofing systems—it also depends on the location, and accessibility, and size of the asset.
3. Prove that you have a good credit record.
You need a good credit score to qualify for a residential mortgage—and an even better one if you’re applying for a commercial investment property loan. If your current score is on the low side, consider improving it before you apply. Be prepared to show the lender documents proving the stability of your income and assets so they can feel confident in your ability to repay the loan.
4. Do the math.
Perhaps you want to buy a building, fix it up, and quickly sell it for profit. Perhaps you are looking to buy a commercial space with lots of reliable tenants to create a solid stream of passive income. Whatever your goals and however you want to make money, make sure that the numbers add up. Do you have a clear revenue plan in place? Lenders want to know how you intend to profit from this venture.
5. Have your down payment ready.
Investment property loans generally require large down payments. The minimum is 20% of the price, but the average is anywhere from 30% to 45% in reality.
Don’t want to tie up your cash in the new property? Find out if you can open a CD (certificates of deposit) with a lender using your down payment money and borrow 100% of the purchase price. Some lenders allow this. Once the commercial real estate asset achieves 25% equity, the lender releases the lien on the CD, and the entire amount plus interest is returned to you.
6. Show a strong debt service coverage ratio (DSCR)
The DSCR refers to the net cash flow (the amount of money the property generates every month from rents and other income sources) vs. its debt service (how much money goes into mortgage payments). This ratio shows lenders how much you can pay each month on your commercial property loan.
For most lenders, the minimum ratio is anywhere from 1.1 to 1.4. A property with a ratio of 1.4 generates $1.40 for every dollar that goes to mortgage payments. It shows that the property’s revenue is larger than its debts—and that theoretically, you should be able to repay the loan.
7. Work with an accountant.
For bigger deals, it certainly makes sense to bring in an accountant who can guide you through investment property tax strategies and help your lawyer review the contracts and put contingencies in place. You might also need an experienced insurance agent. Such advisors may cost money, but they can save you from making expensive mistakes in the long run.
Should you get preapproved for a commercial investment property loan?
Pre-approval is not required, but it doesn’t hurt to have a preapproved loan before you even start searching for potential investment properties. You can work with a mortgage broker to do this. Make sure that the pre-approval is in writing.
A commercial real estate loan broker can really help you increase your chances of getting approved for an investment property loan. Having a broker by your side can make you more competitive in this market, ensuring that your application is attractive in the eyes of lenders and help you get the best outcome from the negotiating table.