As a small business owner, your top priority is to grow your business, and purchasing real estate, renovating a property you already own, or refinancing real estate debt can be a great way to do that.
However, obtaining a commercial real estate loan is a different process than getting a mortgage loan for your primary residence. If you’re considering a commercial real estate loan for your business, here’s everything you need to know before you pull the trigger and apply.
How Do Commercial Real Estate Loans Work?
Commercial real estate loans are designed to help businesses purchase or renovate income-producing properties or refinance real estate debt on a property you already own.
But while commercial real estate loans have the same function as a traditional mortgage loan, there are some key differences small business owners should understand.
The loan-to-value ratio, LTV for short, is a metric that lenders use to determine how much money can borrow. More specifically, they calculate it by dividing the loan amount by the property’s value.
Homebuyers can qualify for a conventional mortgage loan with an LTV as high as 97%, and if you qualify for a first-time homebuyer program or select government-insured loans, you could get up to 100% financing.
With commercial real estate loans, however, lenders typically want an LTV of around 75% to 80%, according to the National Association of Realtors (NAR).
That said, the NAR also found that just 60% of commercial real estate lenders used LTV as a criterion for determining how much a business can borrow. The remaining 40% used what’s called the debt service coverage ratio, or DSCR for short.
The DSCR is used to measure the ability of a business to pay its current debt obligations with its existing cash flow. To calculate it, you divide your annual net operating income by your total debt payments for the year. According to the NAR, the median DSCR is 1.25.
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Personal guarantee vs. non-recourse loans
Whether you get a mortgage or a commercial real estate loan, the lender will use the property as collateral for the debt. But in some cases, it may also require a personal guarantee.
Depending on how long you’ve been in business, your company may not have the financial track record required by the lender to qualify for a commercial real estate loan. In this scenario, the lender may ask the principals or owners to guarantee the loan. This means that if your business can’t repay the debt, you agree to be personally liable for making the monthly payments.
In another scenario, the lender may not require a personal guarantee and simply use the property itself as the only means to recover the loan funds. This is sometimes called a non-recourse loan because the lender has no recourse against the business principals or owners.
Types of Commercial Real Estate Loans
Depending on the needs of your business and its qualifications, there are three primary types of commercial real estate loans that you can use to achieve your goals: permanent loans, SBA loans and bridge loans.
A permanent loan is the first loan on a commercial property, similar to a traditional mortgage loan.
You can typically get a permanent loan from any commercial lender, but they’re not available for short-term financing needs—they typically have an amortization schedule and a repayment term of five years or more.
The U.S. Small Business Administration provides guarantees for some commercial real estate loans, and these loans are often called SBA real estate loans. There are two loan programs under which you can get commercial real estate financing: SBA 7a Loans and SBA 504 Loans. Real estate investors are not eligible for these loans.
SBA 7a Loans
The SBA 7a Loan program is more general in nature, and business owners have a lot of flexibility in how they can use the funds. The loan is even available for non-real estate financing needs, including purchasing inventory and providing working capital.
Also, SBA 7a Loans are provided through a single private commercial lender, and up to 85% of the loan amount is guaranteed by the SBA. Down payment requirements start at 10% but can be much higher depending on the lender and the circumstance.
SBA 504 Loans
With the SBA 504 program, small business owners must use the funds to finance the purchase of commercial real estate or machinery and equipment, renovate an existing commercial property or refinance eligible commercial real estate debt.
Also, SBA 504 Loans are provided through two lenders: a private commercial lender, which provides 50% of the project costs, and a certified development company (CDC), which provides 40%, all of which is guaranteed by the SBA. You provide the remaining 10% as a down payment, though some situations may require more than that amount.
Bridge loans are short-term commercial real estate loans, with repayment terms ranging from six months to three years. Bridge loans are typically used by small business owners who are waiting to apply for long-term financing or a refinance loan.
However, they can also be used by real estate investors who are looking to fix and flip an investment property for short-term gains.
Commercial Real Estate Requirements
Every lender has its own criteria for commercial real estate loans, but there are some important questions to consider before you apply. For example, how much is a down payment on commercial property? And what are the business financial requirements?
For starters, you can generally expect to put down a minimum of 20% most commercial real estate loans (the exception being SBA loans, which start at 10%). Depending on the lender, the situation and your business’ financials, though, you may be required to put down much more.
Also, keep in mind that a higher down payment means a lower monthly payment going forward and lower interest costs.
As for business financials, it depends on the lender. For example, SBA 504 Loans actually have a cap: your business’ tangible net worth cannot exceed $15 million, and average net income cannot exceed $5 million after taxes for the prior two years.
With commercial lenders, you may be required to meet certain minimums, such as at least two years in business under the current ownership and $250,000 in annual revenue.
As you shop around and compare lenders, take note of their requirements to determine whether you qualify. Also, consider both traditional commercial lenders and online lenders in your search. While online lenders typically charge higher interest rates, they can also have less stringent requirements for approval.
Commercial real estate loan repayment schedules
With a mortgage loan, there are plenty of repayment plans you can choose from, but the most common is the 30-year, fixed-rate mortgage loan. With commercial real estate loans, however, repayment terms typically range from five to 20 years, and some loan types provide short-term financing where payment is due within a year.
Also, it’s less common with commercial real estate loans for the amortization schedule to match up with the repayment term. For example, you may get the option for five, 10 or 15 years to pay back your debt, but the amortization schedule goes as high as 25 years.
In this situation, the loan is not designed to be paid in full by the time you complete your repayment term, and your business will need to make a balloon payment at the end to satisfy the remaining balance. If you don’t have the cash required to make the balloon payment, you’ll need to have another commercial real estate loan ready to refinance the remaining debt.
Of course, there are some lenders that offer full amortization, but you’ll need to specifically search for that feature when you’re shopping around.
It’s also important to note that commercial real estate loans typically don’t allow you to pay off your loan early without some kind of fee or penalty. Here are some potential ones you can come across:
- Prepayment penalty: This is typically a percentage of the balance the lender is still owed at the point in the amortization schedule when you pay off the debt early.
- Interest guarantee: With this clause, the lender is entitled to a certain amount of interest regardless of when you pay off the debt. For example, a loan may have a guarantee for 10% interest for the first five years, then a 5% prepayment penalty after that.
- Lockout: With this clause, the borrower is prohibited from paying off the debt early. A common lockout term is five years.
- Defeasance: This process allows small business owners to effectively get out of a real estate loan by providing U.S. Treasury-backed securities as a substitution for the loan’s collateral. To qualify, the securities must generate enough income to cover the remaining principal and interest on the loan. Even so, there may be penalties associated with defeasance.
Interest rates and fees for commercial real estate loans
Commercial real estate loans typically have higher interest rates than mortgage loans, with an average rate of 5% to 7%, according to the NAR. Some lenders may go lower than that range, however, depending on the loan type and structure, and the financials of the business. For small businesses that qualify, for example, SBA 504 Loans typically provide lower interest rates, with averages below 4%.
You can also expect to pay some closing costs, including appraisal fees, origination fees, legal and application fees, and more. These fees typically amount to 1% to 2% of the loan amount, which is much lower than what you’d expect with a residential mortgage loan. If you’re getting an SBA loan, though, you can also expect to pay a guaranty fee, which can be as high as 3.75% of the guaranteed portion of the loan on its own.
Where a commercial real estate loan can get really costly is with prepayment penalties and fees. As you compare lenders, make sure to read the fine print to determine how much you might be charged if you choose to pay off your debt early.
That said, commercial real estate loans don’t require private mortgage insurance like conventional mortgage loans, so you won’t have to worry about this ongoing cost.
Final word: Commercial real estate loans
Commercial real estate loans can provide a great way for small business owners to build or expand their business. With so many options and terms to think about, though, be sure to take your time to find the right loan type and lender for your needs.
Also, consider the right repayment term for your business. A loan with a balloon payment may offer lower monthly payments, but it can cause problems down the road if you can’t make the final payment and can’t refinance the debt.
Finally, when you’re shopping around, take the time to compare each loan based on the full terms, and not just the interest rates and repayment terms. Look at the fine print to find out if there are any penalties for paying off the loan early, and check to see if the lender requires a personal guarantee.
There’s no one-size-fits-all loan that works for everyone, but taking the time to carefully compare each available option will give you a better chance of finding the right fit for your business. Nav’s Business Loan Builder plan can help you get set up for the best loan possible.
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