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Many small businesses operate from rented commercial space, but there may come a time when you want to purchase your own location. If you want to buy commercial space, construct a new building, or remodel existing property, you will likely need to obtain a commercial mortgage.
What is a commercial real estate loan?
A commercial real estate loan, also called a commercial mortgage, is a loan used to purchase or develop commercial property such as office space, retail shops, factories, restaurants, warehouses, or hotels. A commercial mortgage can be used to purchase existing property, perform renovations or expansions to an existing building, construct a new property, or refinance debt.
How does a commercial real estate loan work?
Commercial real estate loans are typically taken out by businesses to purchase or renovate commercial property. Often, the individual owners of the business will need to personally guarantee the loan. In addition, the commercial property you are purchasing typically acts as collateral—meaning that the lender could repossess the property if you fail to pay the loan. Commercial loans also usually require a down payment, often between 10 and 35 percent.
Commercial mortgage terms are typically shorter than those of residential mortgages—commonly, terms can range from five to 25 years. Interest rates, amount of funds available, and terms will vary depending on the lender and the qualifications of the borrower. For most commercial mortgages, lenders will require that your business occupy at least 51 percent of the property.
Some commercial mortgages are amortized loans—loans that you pay back at regular intervals, with interest, until the loan is fully paid off. However, balloon loans are another common type of commercial mortgage. When you pay off a balloon loan, you will pay fixed monthly payments followed by one large balloon payment on the remaining balance of the loan at the end of your loan term.
It should also be noted that interest rates are usually not fixed for more than five years. Your mortgage may specify that the interest rate will reset after five years. There may be prepayment penalties if you want to pay off your mortgage early.
How can you apply for a commercial real estate loan?
Commercial real estate loans typically require extensive documentation as part of the application process. You will need to provide business and personal credit scores, financial records, bank statements, tax returns, and asset and liability statements for the past three to five years. Many lenders require you to have been in business for a certain number of years and have a strong credit history. You will also need to provide a business plan, projected earnings, and plan for using the property.
Be aware that there are a number of fees associated with commercial mortgages, some of which are paid upfront, such as loan application fees and appraisal and survey costs. Because of this, it’s a good idea to make sure you are likely to qualify for the mortgage before applying. Loans are also likely to charge loan origination fees and annual fees.
When they evaluate your eligibility for a loan, lenders will look at your annual net operating income (NOI), which is your income minus expenses such as employee wages, maintenance costs, supplies, and other costs. Lenders will divide your NOI by the amount of your mortgage to determine your debt service ratio. Your income must be sufficiently greater than your annual loan payments such that you will have the cash flow to comfortably repay the loan.
What is a loan-to-value ratio?
It’s important to understand how the loan-to-value ratio (LTV) affects your mortgage. The LTV is determined by dividing the amount of the loan by the value of the property. Generally, you would pay for part of the property yourself via a down payment. If your down payment is larger, your LTV would be lower, while a smaller down payment would result in a higher LTV. You may be able to receive a lower interest rate if your LTV is low, as this means that the lender is bearing less of the risk.
- You buy a commercial property with an assessed value of $200,000. Your down payment is $60,000 (30%) and you will borrow $140,000. The loan amount of $140,000 divided by $200,000 results in an LTV ratio of 70%.
While high LTVs are common with residential mortgages, they are less common with commercial mortgages, where LTVs generally range between 65 to 85 percent.
Where can you obtain a commercial real estate loan?
There are a number of sources of commercial real estate loans.
Banks and Credit Unions
Banks and credit unions are a common source of commercial mortgage loans. Standard commercial mortgage loans typically offer 65 to 80 percent loan-to-value. Well-established businesses (usually with at least two years in business) with strong credit scores are likely to qualify for this type of loan. Many commercial mortgages offered by banks offer fixed or variable interest rates ranging from five to seven percent. Down payments are usually a minimum of 20 percent.
The U.S. Small Business Administration does not directly lend funds, but it guarantees up to 85 percent of loans given by lenders, reducing the lender’s risk and making it easier for small businesses to qualify for a loan. SBA loans can be a great choice for small businesses that would struggle to receive a loan otherwise. SBA loans typically have favorable interest rates and fairly low down payment requirements (10 to 20 percent is common). Interest rates can be fixed or variable. SBA loans generally require businesses to have been established for at least two years.
The SBA’s 7(a) loan program is commonly used for purchasing commercial property. The maximum loan amount for a 7(a) loan is $5 million, and terms are up to 25 years.
CDC/SBA 504 loans can also be used for commercial property purchases. These loans can provide up to 90 percent of the purchase price. Terms are between 10 and 20 years.
Commercial lenders also offer commercial mortgage loans. These loans often have higher interest rates, higher fees, and shorter terms, and they are more likely to require balloon payments. However, they are more likely to lend to borrowers with lower credit scores and less established business histories. The approval process is generally quicker for commercial lenders as compared to traditional banks and SBA loans, as well.
Hard Money Loans
Hard money loans are backed solely by the value of the property as collateral and do not consider the financial credentials of the borrower. They may be options for less creditworthy borrowers. Hard money loans typically have shorter terms, offering up to 70 percent of the value of the property, with common terms ranging from one to three years.
Hard money loans may have less strict requirements for borrowers’ credit scores. Interest rates and fees are often higher for this type of loan. The risk to the borrower is that the property could be repossessed if the loan is not paid. Hard money loans are often used in situations where the borrower plans to renovate a property and resell it.
A bridge loan is a short-term loan, usually with terms from six months to three years. This type of loan is designed to help bridge the gap while the property’s owner secures longer-term financing or sells the property. Bridge loans may offer up to 90 percent of the property’s purchase price. Bridge loans may have high interest rates and generally require collateral. Strong credit scores and a low debt-to-income ratio are required to qualify for this type of loan.
When you make the decision to buy commercial property for your business, you will likely need to obtain a commercial real estate loan to help you fund the purchase. It’s important to consider the types of loans available to you and make sure you are financially prepared before you secure a commercial mortgage, whether it’s for a new property, construction project, or remodeling an existing property.