Whether you’re looking to establish your first physical location or expand into a larger or additional space, you’ll likely need financing for a commercial real estate loan. Much like home mortgages or home equity line of credit, a commercial real estate loan can be used to make a purchase outright, fund needed improvements on a space you already own, or invest in specialized equipment to continue to grow your business. Despite the nature of this loan, meant strictly for businesses, it resembles your typical residential mortgage in structure and terms, but is mostly dependent on a few key factors specific to your business.
However, securing these types of loans can be difficult – and takes more effort than your typical, modern home loan.
If you’re seeking a commercial real estate loan, there are several steps you need to take to even apply – let alone inform yourself on the ins and outs of the industry. Here’s what you need to know before getting started:
Explaining Commercial Real Estate Loans
Just as with residential real estate loans, not all commercial loans are created equal – or suit every business. Each loan type carries its own terms, rates, and approved usages. Before taking on a commercial real estate loan, you need to do your homework and find the right loan product for your needs.
Interest-only loans, also known as balloon loans, are designed for businesses expecting a major financial windfall in the future. These types of loans carry a smaller interest rate with the expectation of a large final payment at the conclusion of the arrangement, which is typically between 3-7 years.
Long-term Fixed-interest Mortgages
Most commercial real estate loans work in much the same way as a home mortgage loan, but with shorter terms. Commercial real estate loans rarely extend to 20 years compared to a home loan’s standard 30 year agreement and tend to sit between 5-10 years in length. There’s also a tougher credit score requirement, requiring business owners to have at least a 700 credit score, a demonstrated minimum of one year of success in business operation, and a 51% occupancy of the property in question.
As with residential mortgages, companies can choose to apply for refinance loans to adjust their interest rates based on market conditions. While there are fees associated with this, companies looking toward the future can save in the long-term and accrue a smaller amount of debt over the lifetime of the loan.
Hard Money Loans
Most business owners seek financing from traditional banks, but hard money loans come from private investors who may have other requirements and terms than FDIC-insured financial institutions. These loans tend to be based on the value of the commercial property and not by the credit scores or finances of the applicant. Hard money lenders want a quick return on investment, so don’t expect the lengthy repayment terms found at a traditional lender – nor the interest rates and upfront costs.
A softer, more lenient version of a hard money loan that offers lower interest rates (typically between 6-9%), bridge loans provide better terms over a longer period. Approvals don’t take as long and funding comes much faster, but companies and business owners need to demonstrate exceptional credit scores and be able to demonstrate projected business growth as well as a 20% or greater down payment.
The upfront costs of land, material, and labor in a new construction are hefty, which is why a construction loan might make sense for companies looking to build and start fresh. These typically last between 18-36 months and end with a long-term mortgage once construction is complete.
Blanket loans are designed for companies with multiple properties or plans to purchase them. These are common among franchises, small chains, and businesses with a viable need for multiple locations. These allow business owners to consolidate financing options for convenience and allow for sales of individual properties without fear of penalty against the loan’s arrangements.
Applying for Commercial Real Estate Loans
Used primarily to either purchase or renovate a building, commercial real estate loans require that the property is owner-occupied, meaning that you can’t take out a commercial real estate loan if you’re leasing space. Because lenders consider the value of the physical property as collateral against the loan, you’ll need to actually own the building (or intend to purchase it) in order to secure the loan.
However, there are some particulars and exceptions. If you’re sharing space with another business and own the building, you can take out a commercial real estate loan – but your primary business will need to occupy at least 51% of the space.
Next, you’ll want to determine the type of commercial real estate loan you’ll need. This depends primarily on the type of business, the property itself, and your current and projected finances.
What Commercial Real Estate Lenders Look for in Applicants
Before applying for a commercial real estate loan, you should inform yourself and your financial team about the requirements that a potential lender will expect during the application process. Here’s how to prepare:
While a commercial real estate loan may look like a residential mortgage or equity loan, the requirements are much more strict – and undergo more scrutiny. Because small businesses are more volatile and subject to more risk as a result of market conditions, the loan terms, and associated interest rates, may be higher than that of a more established company.
Lenders will look at a company’s debt service coverage ratio, which analyzes a business’ annual net income versus the total annual debt. A ratio of 1.25 or better is standard. For example, should a company apply for a $1,000,000 commercial real estate loan, they’ll need to demonstrate the ability to generate a net annual income of at least $1,250,000.
In addition, lenders will check your company’s business credit score to determine your ability to repay your loan and your previous history with debt and credit. Lower scores, as with personal credit scores, will determine the interest rate, payback period, and the required down payment.
Most lenders require a FICO Small Business Scoring Service (SBSS) score of at least 140 – but there are exceptions for companies with collateral or higher personal credit scores.
There are multiple factors for small business owners to consider before applying for a commercial real estate loan, including each partners’ personal credit history and current scores. Businesses should take an honest accounting of stakeholders’ personal credit defaults, any foreclosures, liens, legal actions, and more before applying for a commercial real estate loan.
Property and Collateral
In most commercial real estate loans, the property itself is treated as collateral. The lender attaches a lien to the property, giving them the ability to seize the building due to lack of payment. As mentioned above, these types of loans generally require the business to occupy at least 51% of the building. If that’s not in your company’s real estate equation, an investment property loan may be a better option.
As with most property-based loans, the terms are primarily based on credit score, net income, and property value. Lenders will allow potential borrowers a maximum value based on the loan-to-value (LTV) ratio and calculate the total loan based on that number. This is usually between 65-75%, which would mean your company must provide the remainder of that percentage as a down payment on the commercial real estate loan.
How to Qualify for a Commercial Real Estate Loan and What to Expect from the Application Processing
It’s no surprise that commercial real estate loans require a substantial amount of documentation. If you’re preparing for an application, you’ll need to meet – or exceed – the following threshold:
- – Credit reports on all major stakeholders and the company itself
- – Up to five years of tax tenures and financial records
- – Projected finances throughout the life of the proposed loan
- – Certification of corporation or LLC
- – An independent appraisal of the property in question
- – A complete business plan for the growth of the company, the use of the building and its benefits, and a breakdown of stakeholders’ qualifications and expertise.
Hard money lenders, and traditional lenders considering applicants with tight finances or poorer credit scores, will be more strict with borrowers. If your company has a subpar credit score or can’t secure funding from private or traditional lenders, here are some other options:
- – Consider an SBA 504 or 7(a) loan, which is guaranteed by the U.S. Small – Business Administration
- – Look into grants from non-profit organizations, local business development administrations, or SBA-issued grants
- – Eliminate debt and improve your credit score
- – Bring on additional investors or partners
- – Consider personal or business collateral to demonstrate assets
- – Look at private investment, angel investors, or a peer-to-peer lending group
- – Offer lenders a larger down payment or higher interest rate
While commercial real estate loans are notoriously difficult to secure, being prepared for the application process at the outset – and bringing in your financial team and a commercial real estate broker – will go a long to demonstrate that your company has done its homework and is prepared to take on the financial burden of a monthly loan payment.
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