A commercial property or real estate loan is mortgage loan provided for a commercial property, rather than residential. Financing commercial property can also include the costs for the acquisition, development, and construction of commercial real estate.
How Commercial Loans Are Granted
To qualify a business entity for a commercial real estate loan, lenders look at several factors:
- The loans collateral; the value of the commercial property
- The creditworthiness of the business entity
- The last 3 to 5 years of financial statements and tax returns
- The loan-to-value ratio of the property
- The debt-service coverage ratio
Commercial real estate loans provide a unique situation for lenders since a business entity may not have a financial track record or any credit rating. If this is the case then the lender may require the owners (or principals) of the entity to guarantee the loan. This means the lender has an individual (or group of individuals) with a credit history to base the loan qualification off of – and from whom they can recover payments in the event of loan default.
Although in a non-recourse loan, the lender does not require a guarantee by the owners (or principals) of the business entity to guarantee the loan. Instead, the property is the sole means of recovery in the event of a loan default.
What Qualifies as Commercial Real Estate?
Commercial real estate refers to any income-producing real estate that is used solely for business purposes, such as:
- Retail Centers
- Office Complexes
- Land for Home or Business Development
Who Can Purchase Commercial Real Estate Or Qualify For A Commercial Property Loan?
Typically, it is an investor (often a business entity) who purchases commercial property,and then turns around to lease the space and collect rent from other businesses that wish to operate out of the purchased property. Commercial property loans are made to business entities for the specific purpose of owning commercial real estate. Business entities include:
- Real Estate Investment Trusts (REITs)
Commercial Property Loan Repayment Schedule
Unlike residential loans, the terms of commercial loans typically range from five years (or less) to 20 years, and the amortization period is often longer than the term of the loan, with a final balloon payment at the end of the term.
A commercial loan for a 7 year term is set with an amortization period of 30 year. This means that the borrower would be making payments once a month for seven years, with the payment amount being as if the loan was actually being paid off over 30 years. Once the seven years has been reached, the remaining loan amount is paid in full as a “balloon” payment.
Loan-to-Value (LTV) Ratios
Commercial loans also differ from residential loans in the accepted LTV, which measures the value of a loan against the value of the property.
How is the Loan-to-Value Calculated
Lenders calculate the LTV by dividing the amount of the loan by the lesser of the property’s appraised value or its purchase price. For example, the LTV for a $85,000 loan ($15,000 down payment) on a $100,000 property would be 85% ($85,000 ÷ $100,000 = 0.85, or 85%).
In most cases, the LTV for commercial loans are much lower than those for residential loans. It is common for the loan-to-value to be between 65-80%. The reason being is that there are no commercial FHA or USDA loans, there is no mortgage insurance, or anything to help secure the loan against lost for the lender – aside from the property.
When lenders are preparing to offer a commercial loan they also take into consideration the business’s Debt Service Coverage Ratio (DSCR). The DSCR compares the property’s annual Net Operating Income (NOI) to what the business will have to pay over the course of the year for the loan (including the principal and interest), or the annual debt service. This calculation helps lenders determine what the maximum loan size can be based on the profit that can be generated by the property.
To calculated the DSCR, the lender divides the NOI by the annual debt service. So, for example, if a property has an annual net operating income of $150,000 and the annual debt service for that property would be $100,000, then the Debt Service Coverage Ratio would be 1.5 ($150,000 ÷ $100,000 = 1.5).
A Debt Service Coverage Ratio of less than 1 indicates that the NOI of the property will not be enough to cover the annual debt service. Although anything about 1 shows a positive cash flow, most lenders prefer a minimum of 1.25 before approving a commercial loan.
Interest Rates and Fees
Commercial real estate loans have higher interest rates then residential loan and also have additional fees that residential loans may not have to deal with. Some of the fees are paid upfront during the loan process while others are recurring annual charges. Charges for the appraisal, the loan application, legal fees, loan origination, and survey fees are just some of the additional charges that may be seen during the commercial loan process. These fees are in addition to interest rate charges.
Unlike residential loans, commercial loans may have penalties or restrictions for paying the loan off before the term ends. Prepayment restrictions help protect the yield expected by lenders for providing a commercial loan with all of the assumed risks. There are typically four types of prepayment penalties or restrictions that may be attached to a commercial real estate loan:
- Prepayment Penalty: This is the most common restriction placed on commercial real estate loans and is a fee (usually a percentage) that is tacked onto the remaining loan amount if it is paid off early.
- Lockout: The lender restricts the borrow from being able to pay off the loan before a set period.
- Interest Guarantee: Another option a lender may use is including a specific amount of interest that must be paid by the borrower, even if the loan is paid off early.
- Defeasance: This method can include a higher penalties for early loan payoff. It is when the borrow provides U.S. Treasury securities as collateral for the loan in place of a cash payment.