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If you are a business owner, you may need to buy or renovate a property, which is where a commercial real estate loan (CRE) comes in. Here’s a more in-depth look at the basics of a commercial real estate loan.
What is a commercial real estate loan?
CRE loans exist to finance properties used for commercial purposes, such as shopping malls, warehouses, apartment complexes and office buildings. A CRE loan can be used to purchase a new property, renovate an existing income-generating property, or refinance debt on a commercial property you already own.
Often, CRE loans are issued to a business entity such as a corporation, developer, or trust, although an individual can also borrow one. Most of these loans require the property to be owner-occupied, meaning your business resides in at least 51% of the building.
How Commercial Real Estate Loans Work
Commercial real estate loans work the same way as mortgages for personal real estate. One of the main differences is that the loan is secured by a lien on commercial property rather than residential property. A lien is a legal claim on a property that can be used as security if a loan is not repaid. In the case of a commercial loan, the lender removes the lien once the loan is repaid.
The exact terms of a commercial real estate loan depend on the specific loan type, lender, property being financed and more. Some common types of commercial real estate loans include:
- Permanent loan: It is essentially a first mortgage on a commercial property. It involves some amortization and has a duration of at least five years.
- Loan from the Small Business Administration (SBA): These loans include two main commercial loan programs offered through SBA-7(a) loans and 504 loans.
- Hard money loan: These loans are granted by private companies and are aimed at borrowers who cannot qualify for traditional financing. Although the approval process is often more lenient, the costs can be much higher.
- Bridge loan: These loans work as short-term financing solutions when you need cash to improve or refinance an existing property or to obtain longer-term financing.
Commercial real estate loans: rates and fees
Interest rates on commercial real estate loans tend to be higher than residential loans. They are typically about 0.5% to 1% above the 30-year mortgage prime rate.
Currently, rates range from 3% to 20%, depending on the exact type of loan, property and your personal financial profile. The repayment term can also be shorter for commercial real estate loans, which means they can be a bit more expensive than residential loans.
Also, like residential mortgages, commercial real estate loans have closing costs. As a general rule, these vary between 3% and 5% of the amount borrowed. In the case of SBA loans, you will have to pay a guarantee fee of up to 3.75%, depending on the amount borrowed.
How to get a commercial real estate loan
The process of obtaining a commercial real estate loan is similar to obtaining a mortgage for a house.
- Prepare your file. You will need to provide detailed documentation showing things like your assets, debts, income, and credit profile when applying for the CRE loan.
- Apply for the loan. You can apply for a CRE loan from a bank, credit union, or online lender that offers business loans.
It is important to know that the eligibility requirements for a commercial real estate loan tend to be much stricter than for personal mortgages. Also, the factors considered by lenders may be a bit different.
Related: Best Small Business Loans
Commercial real estate loans vs residential loans
Here’s a closer look at how some of the qualifications for a commercial real estate loan compare to a residential loan.
Your personal credit score gives lenders an idea of your history of borrowing money in the past. A history of paying off your debts on time and in full, for example, usually translates to good credit. Missed payments, overdue accounts, and other issues can lower your credit score.
Similarly, businesses may have their own credit ratings. The FICO Small Business Scoring Service, for example, rates the credit risk of small businesses using a three-digit score ranging from 0 to 300.
The SBA uses the FICO SBSS when evaluating 7(a) loan applicants and requires a minimum score of 140. Some banks also review this score, such as US Bank and Huntington National Bank.
The score needed to qualify for a commercial real estate loan depends on the particular lender, although a score in the 200s is generally considered good. Keep in mind that your personal credit score may also be considered along with your business score.
Loan-to-value ratio (LTV)
In mortgages, the loan-to-value ratio is used to measure the total value of a mortgage relative to the total value of the property. With a traditional mortgage, it is possible to borrow up to the full value of your home (depending on the specific loan program), for an LTV of 100%.
With commercial real estate loans, however, lenders prefer a maximum LTV of 75% to 80%. This means that you may need to deposit at least 20% to 25% (or more) to be approved.
Debt Service Coverage Ratio (DSCR)
Lenders want to know that you are generating enough income to handle new mortgage debt. For residential mortgages, lenders look at your debt-to-income ratio (DTI).
With commercial loans, however, lenders look at a company’s debt service coverage ratio. It measures a borrower’s ability to pay their debts based on the company’s cash flow. It is calculated by dividing your annual net operating income by your total annual debt payments. The higher your DSCR, the higher your chances of approval.
The median DSCR among commercial real estate loans approved was 1.25 in 2019, according to the National Association of Realtors Commercial Loan Report. This means that if you borrowed $100,000, your net operating income should be $125,000 per year.
In most cases, the property financed serves as collateral for a mortgage. However, in the case of a commercial real estate loan, the borrower may also be required to post a personal guarantee.
This means that if the business cannot repay the loan and liquidating the collateral (i.e. seizing the property) does not produce enough money to repay the loan, the borrower is personally responsible for covering the difference.
Read more: What is commercial property insurance?
Choose the right CRE loan
A commercial real estate loan can help business owners finance their property. To find the right loan for your business, you should always compare your options and shop around with several lenders.