Commercial loans allow buyers to finance commercial property purchases. They differ from traditional real estate financing because they are really part business loan and part real estate loan.
This article covers the different types of commercial loans as well as how to find a commercial real estate lender.
How Are Commercial Loans for Real Estate Different?
Commercial real estate financing is not just a bigger residential mortgage. The two differ in significant ways:
- Loan-to-value (LTV) ratios are lower
- Terms are shorter
- Borrower credit and income may be less important
- Fees and interest rates are higher
- Commercial loans take longer to close
The loan-to-value, or LTV, is the property purchase price divided by borrowed amount. So if you buy a $1 million building with $200,000 down, your LTV is 80% ($1 million / $800,000). While owner-occupants can buy residential real estate with 3% down or even zero down, expect to put 20% to 25% down when financing real estate for commercial purposes. However, you may be able to finance some or all of your down payment with a personal loan or business line of credit.
Commercial real estate loans come with either short terms (three years or fewer) or moderate terms ranging from five to 25 years. Shorter loan terms mean you’ll be making a higher monthly payment, or your loan will come with a balloon payment. Balloon payments allow you to keep monthly costs down, but a large lump sum is due at the end of the loan’s term. You’ll have to pay it off, refinance, or sell the property when the lump sum comes due.
Commercial lenders don’t necessarily care as much about your credit as residential lenders do. It depends on your business’s track record — if your company has a five-year track record, stable earnings, and pays its bills on time, your personal credit rating may not be important. However, if your business is new, expect lenders to demand a personal guarantee. And a personal guarantee is not worth much if the guarantor has lousy credit.
Investment real estate lenders want to know that the building’s revenue can cover its expenses, including the loan payment. In some cases, you might have to set up a single-purpose entity (SPE) to protect the lender’s collateral (your building) from claims by any other creditors or third parties. You’ll also want to ensure that your property’s rent revenues can only be used for building-related costs like mortgage payments — not diverted to support other enterprises.
Because lenders have to evaluate the property, the business, and the investor, commercial loans are more complicated, expensive, and time-consuming than residential loans.
Sources of Loans for Commercial Real Estate
Before scouting your first commercial real estate investment, you’ll want to line up your property financing. Serious commercial agents and property sellers will not respect buyers who have not considered funding before shopping.
You can find loans to acquire commercial property for sale from banks, commercial lenders, small business lenders, hard money providers, and owner financing. However, you can’t get preapproved for a commercial property loan the way you can with a residential mortgage because these approvals are property-specific. Instead, you can contact several lenders and get their guidelines so that you won’t consider a property that won’t pass muster.
Note that your plans for the property drive the type of financing you need — if your business occupies at least 51% of the premises, you’ll seek commercial property financing. If you plan to rent out the building to others, you’ll look for an investment property mortgage instead.
Commercial Real Estate Loans From Banks
These loans are similar to residential mortgages. The repayment term is more prolonged (typically 20 to 25 years), and the loan is usually fully amortized, which means there is no balloon payment at the end. That increases the costs but makes the loan less risky.
Banks usually require that the property be owner-occupied and tend to be conservative in their underwriting. Unless your business is long-established and has an excellent credit rating on its own, expect to guarantee the funds personally.
- Pros: Lower interest rates, loan prepayment okay
- Cons: Conservative underwriting, personal guarantee required
Commercial Real Estate Loans From Other Sources
Non-bank sources of commercial property loans include private equity, hedge funds, insurance companies, and REITs. Their terms range from very restrictive to highly flexible.
Life insurers, for instance, tend to prefer lower LTVs, newer buildings, and excellent credit. Their prepayment penalties can be harsh. On the other hand, Real Estate Investment Trusts (REITs) lend rather aggressively, without personal guarantees, for shorter periods. Clients borrow larger amounts because the upfront cost is high for smaller ones.
- Pros: Range of terms and guidelines to meet a variety of needs, personal guarantee not usually required
- Cons: Higher costs and interest rates, prepayment can be very expensive
Conduit Loans (Commercial Mortgage-Backed Securities)
Commercial mortgage-backed securities (CMBS) loans are made by CMBS lenders and then packaged together and sold to bond buyers as securities. This is similar to how Fannie Mae and Freddie Mac package and sell shares of conforming residential mortgages (MBS) to investors. CMBS loans are often larger and usually without personal guarantees. Experienced investors with large projects gravitate to these loans. Closing costs are high, and prepayment penalties can be very costly.
- Pros: Flexible underwriting, large loan amounts, no personal guarantee
- Cons: High cost and punishing prepayment penalties
Private Financing (Hard Money)
Investors often turn to private lenders for quick and dirty financing, or “bridge loans.” A popular source of fast funding is the “hard money” lender.
These lenders base their underwriting decision entirely on property condition and LTV. The maximum LTV for these loans is generally low, especially for borrowers with poor credit. Also, the cost is exceptionally high, with several points upfront and double-digit interest rates.
Hard money loan terms are short, ranging from six months to three years. Businesses might choose hard money loans for emergencies such as crucial repairs. Investors often use them to grab opportunities that won’t wait for traditional financing.
- Pros: Fast and flexible, borrower credit is less important, prepayment okay
- Cons: Very expensive, loan terms are short
Small Business (SBA) Loans
The US Small Business Administration guarantees commercial real estate financing with SBA 504 and SBA 7(a) loans. These are for businesses that will occupy at least 51% of the property; real estate investors are not eligible.
To apply for a CDC/504 loan, you need to present a solid business plan and prove business management experience. Your business must be worth less than $15 million and have less than $5 million after-tax net income. You must also show that you can’t buy the real estate with other funds.
You can only use the funds to finance the purchase of commercial real estate or machinery and equipment, renovate an existing commercial property, or refinance an eligible commercial real estate loan.
The SBA 7(a) loan program offers more flexibility in how you can use the funds — even for non-real estate financing needs like purchasing inventory or making payroll. Both SBA loans allow down payments as low as 10%.
- Pros: Terms are longer and down payments are lower
- Cons: Application is time-consuming, a personal guarantee is required
How to Find a Commercial Real Estate Lender
The best source for commercial property financing depends on the property’s use, your business credit rating strength, individual resources and credit score, and time frame. Your real estate agent or transaction coordinator may be able to refer you to some reliable lenders, but you’ll also want to get quotes independently.
There is a wide range of bank and non-bank commercial real estate lenders, and finding the right one might be a challenge for the first-time investor. In that case, a commercial real estate loan broker can help you find the best option for your situation.
When negotiating your loan terms, request quotes from several lenders (you can include a broker in this mix) and compare them side-by-side. A commercial real estate loan calculator can help you determine which loan costs the least amount and best meets your needs.
Ben Mizes is the Co-Founder and CEO at Clever Real Estate, the nation’s leading real estate education platform for home buyers, sellers, and investors.