Have you ever wondered, “How do commercial real estate loans work?”
Commercial real estate loans are very different from traditional real estate loans (like the one you would get to buy a home) and the process can be quite complex. Investing in commercial real estate can be an excellent way to start or grow your business. However, unless you have enough cash on hand to purchase the property outright, you’re going to need a commercial real estate loan.
We’re going to break down everything you need to know about how commercial real estate loans work, what the different types are, and how to qualify for a commercial real estate loan.
Please note that this guide is designed to help you navigate the commercial real estate loan process. It does not constitute as financial advice.
What are Commercial Real Estate Loans?
Commercial real estate loans (also called CRE loans) help business owners secure properties they can use to generate income. CRE loans are similar to residential real estate loans in that both are types of mortgages that are used to purchase real estate. But the two types of loans are more different than they are alike.
CRE loans are specifically designed to finance the purchase or remodel of property that will be used for business purposes. Therefore, to be approved for a CRE loan, the majority of the building you purchase is required to be used for business purposes.
That means you can lease out a portion of the property if you wish. But at least 51% of the property must be used for your business. If you want to lease out 50% or more of your commercial property, you will have to apply for a separate type of loan.
When to Apply for a Commercial Real Estate Loan?
Here are four situations in which a commercial real estate loan would be appropriate:
- Buying an office building or suite to operate your business out of
- Expanding or relocating a retail store
- Investing in a warehouse to store inventory
- Purchasing, building or modifying a hotel that you intend to operate
Benefits of Commercial Real Estate Loans
Although the process of obtaining a CRE loan can be complex and expensive, it’s almost always worth it in the end. After securing a CRE loan, you can benefit from:
- Rental property income
- Tax benefits
- Sale proceeds
- Operating expense recovery
- Parking, vending, and services fees
How do Commercial Real Estate Loans Work?
Commercial real estate loans are funds that are used to purchase an existing property. They can also be used to develop, construct, or renovate land or a building. In most cases, CRE loan applicants will have to be owners of a legal business entity that is registered with the state and local governments.
Here are a few other stipulations and terms for how to qualify for a commercial real estate loan:
|Down payment||15%-35% (certain loans back by the U.S. Small Business Administration may be secured with as little as 10% down)|
|Loan terms||5-10 years, with up to 25-year payoff plans|
|Debt-to-income requirement||Minimum of 1.25|
|Minimum credit score||660|
|Eligible property types||Office, retail, industrial, hotels, restaurants, medical, entertainment, and specialty|
Loan-to Value Ratio
The Loan-to-Value (LTV) ratio is used by mortgage lenders to determine how much money they can lend to a business owner. The LTV is found by dividing the loan amount by the property’s value.
CRE lenders typically want to see an LTV of 75%-80%. This could mean that you will have to either purchase an undervalued property or a sufficient down payment (around 25%) before you begin the CRE loan application process.
That being said, not every CRE loan lender uses LTV to determine how much they will lend a business. Some use a debt service coverage ratio (DSCR), which is used to determine a business owner’s ability to pay off their current debt. DSCR is calculated by dividing your business’ annual net operating income by your total debt payments per year. The median DCSR is 1.25.
Personal Guarantee vs. Non-Recourse Loans
When you are approved for a CRE loan, you are allowing the lending company to use your new business property as collateral for the debt. In certain circumstances, lenders might also require a Personal Guarantee.
If your business has not been in operation for long, you may not have the financial track record to prove that you qualify for a CRE loan. If that’s the case, a lender may ask you to guarantee that youwill personally pay back the loan if your business cannot.
Instead of a personal guarantee, lenders may offer a Non-Recourse Loan. In this situation, the lender will require that the property covers the loan funds if your business cannot. Meaning that the lender will reclaim the property and default your loan.
How to Get a Commercial Real Estate Loan
Here is a quick, yet comprehensive, guide to applying for a securing a commercial real estate loan.
- Know Your Credit Score
Your credit score is one of the most important factors when it comes to borrowing money. As a registered business, you will have a business credit score that is completely separate from your personal credit score.
While personal credit scores range between 300-850, business credit scores are on a 100-point scale:
- Very poor: 0-20
- Poor: 21-40
- Fair: 41-60
- Good: 61-80
- Excellent: 81-100
If you want to obtain a commercial real estate loan with as little money down as possible, you will have to have a nearly perfect business credit score. In addition, scores in the Excellent range will have lower interest rates and better payback terms.
- Understand Other Requirements
You want to begin the CRE loan application process as prepared as possible. You should come prepared with the following information:
- Years your business has been in operation*
- Value of collateral assets
- Debt-to-income ratio**
- Annual revenues
*It’s recommended that your business has been operating for at least 2 full years before you apply for a CRE loan.
**Your gross income should exceed your total debts. This will make lenders confident that you have the means to repay your loan.
- Determine the Type of Commercial Real Estate Loan You need
There are 5 types of CRE loans available to business owners:
- Permanent Loan: Permanent loans are the most similar to traditional mortgage loans. Typically, business owners can obtain a permanent loan from any commercial lender, but they cannot be used for short-term financing – typical amortization schedules and repayment terms are 5-years or more.
- SBA Loan: The U.S. Small Business Administration backs some commercial real estate loans for small businesses. These loans are not available for real estate investors.
- Bridge Loan: Commercial bridge loans are short-term financing solutions that are designed to help “bridge the gap” between current and long-term financing. Finds for bridge loans can typically be secured quickly, but they come with high-interest rates.
- Line of Credit: A line of credit can be issued to help a business pay for immediate needs. The amount available to a business is pre-approved by the lender and can be used how the business sees fit.
- Hard Money Loan: A hard money loan is thought of as a “last resort” that can be used for real estate transactions. They rely on collateral, not the financial standing of the business.
- Owner Financing: Owner financing loans are loans that come from the entity that is selling the piece of commercial real estate a business owner is interested in buying.
- Choose a Commercial Real Estate Lender
There are thousands of commercial real estate lenders for you to choose from. The best lender for your business will depend on what type of loan you need, how much you need to borrow, and what your future financial plans are.
Here is a list of things to consider when choosing a commercial real estate lender:
- Available loan options
- Origination fees
- Starting interest rates
- Documentation requirements
- Time-in-business requirements
- Prepayment penalties
- Personal-guarantee requirements
- Fast-funding or bad-credit options (if you need them)
- Better Business Bureau ratings and customer complaints
Commercial Real Estate Loan FAQ
Are commercial real estate loans different from mortgages?
Yes. Commercial real estate loans have different requirements, rates, terms, and characteristics than personal loans.
What is the minimum down payment for a commercial real estate loan?
Typically, commercial real estate lenders will ask for at least 25% down. However, you may not be required to put as much down if your business has an excellent credit score.
How long does it take to pay back a commercial real estate loan?
Commercial real estate loans typically have repayment plans that are 5-10 years long. However, amortization plans can last for up to 25-years.