A commercial real estate loan can benefit small businesses looking to expand/renovate their job site or commercial real estate investors purchasing income-producing property. A loan note, also known as a mortgage note or promissory note, is similar to a more advanced form of an IOU. With a loan note, the lender receives payments from a borrower over a certain period of time until the date that the entire loan needs to be repaid.
You can obtain a CRE loan from banks, insurance companies, independent lenders, private investors, and even via the U.S. Small Businesses Administration’s 504 loan Program. However, due to the money and liability involved, commercial real estate loans are usually more expensive than residential loans.
How to Qualify for a Loan Note
To get a commercial real estate loan, you generally need to have a credit score of at least 660 and make a minimum down payment of 25% of the property purchase price. A borrower must also use most of the property for their own business or as an income-producing investment and use the property as collateral.
What is the Term Length of a Loan Note?
CRE loans are usually shorter than residential loan options, with terms ranging from 5 to 20 years. In addition, the amortization period (the process in which you repay the loan through payment installations) often lasts longer than the loan itself.
For example, if you have a property loan with a term of 10 years and a 30-year amortization, you would make monthly payments for ten years. Lenders consider the monthly loan repayment within 30 years, with the last charge consisting of the remaining balance, known as a “balloon payment.”
Loan Note Ratios to Know
When applying for a loan note, lenders look at credit history and worthiness of the borrower. These criteria include providing three to five years’ of financial statements, income tax returns, and financial ratios.
There are three main ratios that commercial lenders utilize when deciding whether or not to approve a commercial loan request. These ratios are loan-to-value ratio (LTV), debt service coverage ratio (DSCR), and debt ratio.
1. Loan-to-value ratio (LTV)
Your loan-to-value ratio is your commercial mortgage divided by the property’s market value. LTV ratios for commercial real estate loans are usually capped at a maximum of 75%.
A borrower with a high loan-to-value ratio is considered a higher risk because the borrower has less “skin in the game” or fewer personal funds invested in the property.
2. Debt-service coverage ratio (DSCR)
The debt service coverage ratio (DSCR) is the ratio of net operating income (NOI) divided by the annual debt service. DSCR is a common way to gauge if a borrower has enough cash to cover its debt. As a rule of thumb, the greater the ratio is, the easier it is to get a loan.
Below is the formula used to calculate your DSCR:
- DSCR = Net operating income/Debt Service
3. Debt Ratio
Some lenders may also calculate a borrower’s personal debt ratio when underwriting a commercial real estate loan. There are two types of debt ratios:
- Top Debt Ratio compares a borrower’s first and second mortgage payments on a primary residence to earned gross income.
- Bottom Debt Ratio compares a borrower’s total mortgage payments plus personal debt payments (such as auto and school loans) to gross income.
The rationale for calculating debt ratio is that if a borrower is over-extended with personal debt, the odds of potentially defaulting on a commercial loan may increase.
Secured vs. Unsecured Loans
The most significant difference between secured and unsecured loans is that you must provide a physical item of value to be used as collateral if you cannot pay back the loan. You can borrow the money without collateral with unsecured loans, but the lender needs to first review and approve your financials.
Most people offer the property as collateral when taking out a secured loan. In some cases, a lender may also require a borrower to cross-collateralize a loan with personal assets. Some other items you can provide as collateral include:
- Insurance policies such as life insurance
- Real estate, such as a primary residence
- Bank accounts/stocks/bonds
It is important to note that lenders can seize your asset(s) if you don’t pay back your secured loan. In addition to paying interest on the loan, you may also need to pay certain fees when taking out a secured loan.
An unsecured loan does not require collateral, but you will still be charged interest and possibly fees. However, since you are not offering any valuable possessions, your lender will look closely at your credit score and payment history. Examples of unsecured loans include credit cards, personal loans, and student loans.
Most commercial loan interest rates range from 3.5% to 20%. There is a wide range as interest depends on various factors such as the property’s location, property type, financial history of the borrower, LTV and DSCR ratios, and more.
One of the requirements for getting a commercial loan note is making a down payment. A down payment is usually a minimum of 25% of the property purchase price, excluding closing costs. The down payment may increase or decrease depending on the financing and loan you are using.
The Bottom Line
Commercial real estate loans help finance the property for many different uses, whether you plan to use as your own business, renovate the property, or purchase it as an income-producing investment. While taking out a CRE loan note can be a lengthy and sometimes risky process, it can be advantageous and even necessary when investing in commercial real estate.
Make sure to pick a lender you trust and look for a low commercial mortgage rate. Do not rush this process: the total amount of debt service will have a significant financial impact on your business and return on investment.