Understanding the Basics of Commercial Real Estate Financing

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Commercial real estate is a unique investment that offers prodigious opportunity. Those already immersed in this segment have developed key relationships that will contribute to future years of success. As many commercial real estate investors understand, finding a property is not always the only concern; acquiring the right commercial real estate financing is. There are numerous options for commercial real estate financing from different types of lenders, which can aid in the accumulation of one or more commercial properties. To recognize the key distinctions between commercial and residential loans, understanding the basics of commercial real estate financing is essential.

The Basics of Commercial Real Estate Loans

Commercial real estate loans are specific financing options given to borrowers looking to purchase commercial or commercially zoned property. The types of properties for commercial loans vary but are only eligible for financing if they are going to be used for business purposes and therefore, produce income—they are not subject to primary residential loan compliance and regulation. Commercial real estate loans are not approved for individuals to use as a primary residence, so you will need to have an established operating business or entity that will hold title and qualify for the loan.  

Each commercial loan is unique, and specifications depend on which financing option you choose. Borrowers will need to provide collateral and/or some sort of guarantee in exchange for the loan. If you receive a commercial property loan and are unable to meet the agreed upon repayment terms, property seizure may occur; this is commonly known as foreclosure.

Understanding How Commercial Real Estate Loans Work

Unlike residential loans, commercial real estate loans are only used for business purposes. Investors that inquire about commercial loans must have proof of an established business or income generating activity to qualify. In every instance, lenders require property as collateral to secure the loan request so that appropriate action can be taken should the loan go into default. With every commercial real estate loan request, there is a very stringent underwriting process whereby lenders analyze and review the income sources of the property or the business to determine whether the loan can meet the ability to repay the loan.

Duration of Commercial Real Estate Loans

The length of commercial real estate loans varies depending on the type of financing you utilize. Some commercial real estate and multifamily loan options can extend up to 30 years or more, while other options—like bridge loans—can last as little as only a few months. Many commercial real estate loans have amortization periods that last longer than the loan terms. In these instances, you would need to pay monthly payments for the loan terms and then pay the remaining balance off at the end of the loan term. These types of loans are called balloons; meaning there is an amount due at the end of a fixed rate period. As an example, a five-year loan with an amortization period of 15 years would have payments for five years and then would have to either pay off the entire loan or refinance the unpaid principal balance at the end of the 5th year. The loan repayment would be cast as if it were being paid back within 15 years, although the fixed portion would be for 5 years.   

Different financing options have different loan terms and amortization periods, so it’s essential that you understand how these things will affect you and the property when you move forward with financing.

Commercial Real Estate Interest Rates

Interest rates are set in many ways for all different types of properties and borrowers. Some lenders will make balance sheet loans, whereby their cost of capital is directly tied to their deposits. This is standard for most banks that lend on balance sheet. As you explore larger loan amounts, most lenders will formulate their total interest rates based upon an index, such as LIBOR, SOFR or the 10-year Treasury plus a spread.

The SBA is another vehicle that provides up to 90% financing secured by a government guarantee that typically carries lower interest rates in order to help small business acquire real estate and expand their business operations.

Loan Repayment Terms

Repayment periods range anywhere from one (1) to twenty (20) years based on financing options and lenders. Amortization periods typically extend past loan terms, but these details vary. It’s typical to hear lenders say loan terms such as 25 due in 10. This means the loan is amortized over 25 years, but only fixed for 10 years; whereby there is a balloon payment at the end of that 10th year. The length of your repayment term and amortization period for commercial real estate loans will affect your interest rate.

Different Options for Commercial Real Estate Financing

When exploring the purchase or refinance of a commercial property, it’s imperative for borrowers to determine what their short- and long-term goals are with the property. Once the plan is outlined, it becomes easier to find the correct financing options. Each option offers different benefits, so finding one that will work best for you is paramount to your success. The most common distinctions in commercial real estate finance are whether the property is used as an owner-user or investment. Some of the different options to secure financing for commercial real estate property include the following.

SBA Loans

SBA loans are a very useful loan program for small-mid sized business owners seeking to acquire commercial real estate with as little as 10% down. SBA loans can lend up to 90% of the total project cost and/or purchase price. With the SBA, there are two (2) programs; 7a and 504.

  • SBA 7(a)

SBA 7(a) loans are good for smaller projects and are tailored to borrowers looking to either purchase or refinance businesses and commercial properties up to $5,000,000. SBA 7a loans are only available to operating businesses, not commercial real estate investors. Approval is fast and easier than other types of SBA loans due to the limitations on lending. The benefit of an SBA loan is that they lower lender risk, which can help increase approval rates for borrowers. The government provides these guarantees to ensure small businesses receive access to capital to grow their business and hire in the communities they operate and serve. SBA 7a financing is a widely used option when securing an SBA loan.

  • SBA 504

For business owners and borrowers who need a commercial real estate loan up to and over $5,000,000, SBA 504 loans can be a great option. While there may not be stated maximum loan amounts, most SBA 504 loans typically cap out around $20 million. The SBA 504 loan will lend up to 90% of the total property value or project cost. The 504 loan is comprised of two loans: a 1st and 2nd Deed of Trust. The 1st loan is traditionally originated by a bank or direct lender up to 50% of the purchase price and the 2nd loan goes up to 40%, bringing the total loan for the project to 90% financing. The 2nd loan comes from a Certified Development Company aka “CDC”. The CDC is a non-profit organization that originates and approves loans on behalf of the government. 

Conventional Bank Loans

Conventional loans are financed through FDIC insured banks and credit unions, who require a borrower to have strong credit, at least 2 years in business, and be profitable. Due to competitive interest rates, borrowers who qualify for traditional loans often utilize this financing option. Nearly all conventional bank loans require a large down payment typically ranging from 20% – 25%, so if you do not have the capital other options should be prioritized. Loan terms can vary, and certain lenders may charge penalties for early repayment. 

Commercial Bridge Loans

Commercial bridge loans, also known as hard money loans, are ways for investors to utilize capital to close on time-sensitive and non-bankable deals. Bridge loans are best used when borrowers need immediate financing and are only held until more long-term solutions can be secured. Financing is secured in days or weeks instead of months so borrowers can close on deals. Interest rates for bridge loans may be higher than other financing options and repayment periods are shorter. Bridge loans are typically interest only and don’t have any principal repayment.  

Different financing options are offered by different entities and each requires individual parameters to be met for eligibility. Finding the right lender is the best way to ensure that you’re setting yourself up for success.

Requirements for Obtaining a Commercial Real Estate Loan

To obtain a commercial real estate loan, you need to meet a certain set of requirements. These requirements can vary based on financing options and lenders, but as a rule of thumb, the following apply.

Credit History

Having an established credit history when acquiring commercial real estate financing is considerably more important than what your credit score is. While you’ll need a minimum of 680 or higher, those without credit history have more difficulty securing capital. If you have tax liens, foreclosures, or bankruptcies in recent credit history, the financing process becomes more difficult and may require a larger down payment. It may also carry a higher interest rate due to the risk the lender believes could pose the repayment capability of the borrower.

Business Entity

As previously mentioned, you need to have an established business entity before applying for financing. Commercial real estate investors will typically hold title or operate their business with through some sort of legal corporation.  

Loan-to-Value (LTV) Ratio

The loan-to-value (LTV) is a ratio that lenders use to measure the overall correlation of a loan to the value of the commercial property. It’s calculated by dividing the loan amount by the value of the asset, or the commercial property purchase price. If you needed to take out a $600,000 loan and the commercial property was $800,000, your LTV would be 75% or 0.75 ($600,000 ÷ $800,0000 = 0.75). When acquiring commercial real estate financing, the lower the LTV, the better. Low LTVs are seen by lenders as low risk and therefore, you’ll receive better financing rates.

Debt-to-Service Ratio

The debt-to-service ratio (DSCR) is a ratio that’s used to compare a commercial property’s annual net operating income (NOI) to the annual mortgage debt service. This allows lenders to understand how a property will be able to service its own debt over time. If your property has $200,000 in NOI and is paying $150,000 towards mortgage debt each year, then the DSCR would be 1.33 ($200,000 ÷ $150,000 = 1.33).

An ideal DSCR is going to be over 1.25, as anything less than this indicates weak cash flow. Lenders use this when determining whether to finance commercial real estate properties and what the maximum loan size will be.

Finding the Best Commercial Real Estate Financing

To find the best financing for your next commercial real estate need, it’s important to work with professionals that understand the business or underlying investment purpose of the loan request. It always safe to assume that most commercial real estate loans can take anywhere between 45 and 60 days.

If you are looking for a streamlined process to commercial real estate financing, contact PACT Capital. As commercial real estate capital advisors and direct private lenders, we act as an intermediary between borrowers who need commercial real estate financing and lenders who provide it. This allows us to place borrowers with the lender best suited for their immediate financing needs while positioning them in line to achieve their long-term goals. To learn more about our bridge-to-perm financing options, contact PACT Capital by emailing info@PACTCap.com, or calling 213-799-PACT (7228).