They say that if there’s a will, there’s a way, and that’s especially true when it comes to financing and investing in commercial real estate. By understanding how to work with a commercial real estate lender and what lenders look for, a real estate investor can increase the odds of obtaining the funds to develop, purchase, or reposition a property investment.
Leverage in commercial real estate is used to help increase potential returns by using borrowed money. Even though origination volume in Q2 2023 was down 53% compared to Q2 2022 data, according to the Mortgage Bankers Association, they’re still a crucial element in the acquisition process and potential ROI of commercial property.
In this article, we’ll discuss how to work with a commercial lender, including tips on qualifying for a commercial loan and where to find funds for your next commercial real estate transaction.
Commercial Real Estate vs. Residential Loans
Residential loans generally require a low down payment, have a fixed or variable interest rate, and are fully amortized over 15-30 years. On the other hand, commercial loans come in all shapes and sizes and may be customized to meet the unique needs of a borrower and a commercial lender.
Some of the critical characteristics of a commercial real estate loan include:
- Investment property purchased for business use, development or redevelopment, or income-producing property.
- Higher Interest rates and larger down payments than with a residential loan, often 25% or more of the property purchase price.
- Loan term length is typically 5-20 years, with payments amortized over a more extended period.
- Balloon payment due at the end of loan terms requires refinancing or selling the property.
- The lender may require the borrower to have commercial real estate investing experience.
How to Qualify for a Commercial Real Estate Loan
A commercial lender typically has higher qualification standards compared to residential. One of the reasons for this is that traditional lenders generally view commercial loans as having more risk than buying a principal residence.
Commercial property is normally purchased by a business or business entity such as an LLC or S-Corporation. A commercial lender will review a business’s credit rating and historical financial performance to help ensure the borrower will repay the loan. Personal guarantees may be required if a company is new or if the borrower lacks experience with commercial real estate investing.
A lender will also review the personal finances of the business principals applying for a commercial loan. Suppose one or more principals has a low credit score or marks on their credit report, such as default or foreclosure, judgment, or tax lien. In that case, a lender may insist on more stringent loan terms or decline a commercial loan application altogether.
Characteristics of the property also impact the loan terms and conditions. For example, if a business is purchasing a commercial property for its own use, a lender will generally require that the company uses 51% or more of the building.
Suppose a buyer seeks to acquire an income-producing property, such as an apartment building or suburban office complex. In that case, a lender will review factors such as the historical occupancy rate, credit quality of each tenant, building maintenance history, and cash flow and net operating income generated by the investment.
Loan to value (LTV)
The loan-to-value ratio or LTV compares the loan amount to the property’s appraised value. If a commercial property is purchased for $5 million with a down payment of $1.5 million and a mortgage of $3.5 million, the LTV would be 70% ($3,500,000/$5,000,000).
While residential loans generally require very low down payments, commercial lenders typically look for a down payment of 25% or more. The required down payment may vary based on borrower credentials, the type of property being purchased, and the purpose of the loan (such as an owner-occupied building versus repositioning a retail property for mixed use).
Debt service coverage ratio
The debt service coverage ratio (DSCR) is a metric commercial lenders use to help ensure a financed property generates enough cash flow to cover the monthly loan payments and property operating expenses.
To illustrate, assume an office building has an annual net operating income (NOI) of $500,000 before any mortgage payments. If the annual debt service is $350,000, the DSCR would be 1.43 ($500,000/$350,000).
The higher the DSCR is, the more cash available to service the debt, and the lower the risk to a lender. On the other hand, a property with a DSCR of fewer than 1.0 means cash flow will be negative after paying operating expenses and servicing the debt.
Other terms and conditions
Commercial real estate loans often contain specific terms and conditions that typically don’t appear in residential loans:
- Higher interest rates based on borrower’s business and personal credentials, type of property being financed, LTV, and DSCR.
- Larger loan fees due to specialized appraisal, application and origination fees, environmental inspections, and surveys.
- Prepayment restrictions or penalties if the loan is refinanced or the property is sold before the end of the loan term.
Applying for a Commercial Real Estate Loan
The application process for a commercial loan is similar to a residential loan, although more paperwork is involved and the approval process may take longer. Typical information and required documents for commercial lenders include:
- Business tax returns
- Credit report of business
- Financial reports going back three years
- Personal tax returns of principals
- A credit report for each principal
- Personal financial statements going back three years
- Several months of bank statements
- Details of the property being purchased
- Current rent roll
- Financial performance of property going back three years
- A business plan describing the use of the financed property
Types of Commercial Real Estate Loans
There may be various sources for financing commercial real estate, including crowdfunding or P2P crowdlending platforms. Here are five of the most common options for commercial lending:
Traditional loans are typically issued by national and regional banks and local credit unions. They may be a good option for financing a commercial property, especially if a borrower already has a relationship with the bank.
Loans from the Small Business Administration (SBA) are designed for commercial property that the borrower primarily occupies. There are two main types of SBA loans:
- The SBA 7 a loan, used for purchasing real estate.
- The SBA 504 loan, used for financing equipment or other major assets, an existing building, or land.
Businesses can obtain a bridge loan, or short-term loan, to procure funds when a property is being renovated or leased up until long-term financing. Interest rates are typically higher than other types of commercial funding, and loan terms are generally for one year or less.
Private and hard money loans may be a good source of funds for borrowers looking for creative financing. Private companies and individuals that make these loans focus more on the property’s value and will take the property back and sell it or take over the project if a borrower defaults on the loan. Parties can customize terms and conditions to meet the specific needs of a borrower and lender and generally require much less documentation.
Blanket financing is used to purchase multiple properties at the same time. Rather than applying for several individual loans, a borrower would apply for a single blanket loan covering the entire purchase. Properties in a blanket loan are cross-collateralized, with individual properties serving as collateral for one another. Often a blanket loan will include a partial release clause that allows one property to be sold without refinancing the rest.