Commercial Real Estate Loans: What You Should Know

If you’re a business owner, you might need to buy or renovate property—that’s where a commercial real estate (CRE) loan comes in. Here’s a closer look at the basics of a commercial real estate loan.

What Is a Commercial Real Estate Loan?

CRE loans exist to finance property that’s used for business-related purposes, such as shopping malls, warehouses, apartment complexes and office buildings. A CRE loan can be used to buy new property, renovate existing income-producing property or refinance debt on a commercial property you already own.

Often, CRE loans are made to a business entity such as a corporation, developer or trust, though an individual can borrow one as well. Most of these loans require that the property is owner-occupied, meaning your business resides in at least 51% of the building.

How Commercial Real Estate Loans Work

Commercial real estate loans work similarly to mortgage loans for personal real estate. One of the main differences is that the loan is secured by a lien against the commercial property rather than a residential property. A lien is a legal claim to a property that can be used as collateral if a loan goes unpaid. In the case of a commercial loan, the lender removes the lien once the loan is paid off.

The exact terms of a commercial real estate loan depend on the specific type of loan, lender, property financed and more. Some common types of commercial real estate loans include:

  • Permanent loan: This is essentially a first mortgage on a commercial property. It involves some amortization and has a term of at least five years.
  • Small Business Administration (SBA) loan: These loans include two main commercial loan programs offered through the SBA—7(a) loans and 504 loans.
  • Hard money loan: These loans are provided by private companies and are designed for borrowers who can’t qualify for traditional financing. Though the approval process is often more lenient, the costs can be much higher.
  • Bridge loan: These loans work as short-term financing solutions for when you need cash flow to improve or refinance an existing property or work on getting longer-term financing.

Commercial Real Estate Loans: Rates and Fees

Interest rates on commercial real estate loans tend to be higher than those for residential loans. They’re typically about 0.5% to 1% higher than the 30-year prime rate for mortgages.

Currently, rates range from 3% to 20%, depending on the exact type of loan, property and your personal financial profile. The repayment term may also be shorter for commercial real estate loans, meaning they can be a bit more expensive than residential loans.

Also, like residential mortgages, commercial real estate loans come with closing costs. Typically, these range between 3% and 5% of the amount borrowed. In the case of SBA loans, you’ll need to pay a guaranty fee of up to 3.75%, depending on the amount borrowed.

How to Get a Commercial Real Estate Loan

The process for getting a commercial real estate loan is similar to getting a mortgage for a home.

  1. Prepare your documentation. You’ll need to provide extensive documentation showing items including your assets, debts, income and credit profile when applying for a CRE loan.
  2. Apply for the loan. You can apply for a CRE loan through a bank, credit union or online lender that offers commercial loans.

It’s important to know that the eligibility requirements for a commercial real estate loan tend to be much stricter than for personal mortgages. Plus, the factors that lenders consider can 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.

Credit

Your personal credit score gives lenders an idea of your track record with borrowing money in the past. A history of paying back your debts on time and in full, for instance, usually results in good credit. Missed payments, accounts in collections and other problems can cause your credit score to drop.

Similarly, businesses can have their own credit scores. 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 look at this score, such as U.S. Bank and Huntington National Bank.

The score needed to qualify for a commercial real estate loan depends on the particular lender, though 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 (LTV) Ratio

In mortgage lending, the loan-to-value ratio is used to measure the total value of a mortgage compared to the total value of the property. With a traditional mortgage, it’s 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 you may need to put at least 20% to 25% (or more) down to be approved.

Debt Service Coverage Ratio (DSCR)

Lenders want to know that you generate enough income to handle new real estate debt. For residential mortgages, lenders look at your debt-to-income (DTI) ratio.

With commercial loans, however, lenders look at a business’s debt service coverage ratio. This measures a borrower’s ability to pay their debts based on the business cash flow. It’s calculated by dividing your annual net operating income by your total annual debt payments. The higher your DSCR, the higher your approval odds.

The median DSCR among approved commercial real estate loans was 1.25 as of 2019, according to the National Association of Realtors Commercial Lending Report. This means if you borrowed $100,000, your net operating income should be $125,000 per year.

Personal Guarantee

In most cases, the property being financed serves as the collateral for a real estate loan. In the case of a commercial real estate loan, however, the borrower may be required to make a personal guarantee as well.

This means that if the business can’t make the loan payments and liquidating collateral (i.e., foreclosing on the property) doesn’t produce enough money to repay the loan, the borrower is personally responsible for covering the difference.

Read More: What Is Commercial Property Insurance?

Choosing the Right CRE Loan

A commercial real estate loan can help business owners finance property. To find the loan that makes sense for your business, you should always compare your options and shop around with multiple lenders.

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