Commercial loans are there to help businesses looking to purchase a piece of real estate.
While they do bear some similarities to a traditional home mortgage, commercial real estate loans are intended specifically to buy property for commercial use.
Small business owners typically take out commercial loans for one of two reasons, which are:
- To purchase a location for their business to operate out of.
- Or, to buy an income-producing retail property.
In this article, we will cover the different types of commercial loans, commercial loan rates, how to get a commercial loan, and what lenders look for in prospective borrowers.
What Are Commercial Loans?
Quite simply, a commercial loan is a type of small business loan that is designed specifically for commercial real estate purchases.
These loans are often made to business owners who wish to purchase an income-producing property.
Unlike residential loans, where the borrower is an individual or a couple, commercial loans are typically made to a business entity.
And while a residential mortgage is typically 30 years, terms for commercial loans can vary.
While some may be just as long as a consumer mortgage, others can be as short as a few months.
When deciding whether or not to make a commercial loan, lenders look at several criteria, including:
- The loan’s collateral.
- The creditworthiness of the business entity requesting the loan.
- Three to five years of financial statements and income tax returns.
- Financial ratios, such as the loan-to-value ratio and the debt-service coverage ratio (more on what those are later).
Learn more about how commercial loans are approved with the 5 Cs of Credit
In the case of a recently-formed business entity with no credit history, lenders might require that the business owner personally guarantees the loan.
This gives the bank or other lenders an individual credit history and financial track record they can review.
Then if the business should default on the loan, the lender can then pursue payment from that individual (or individuals if several business owners guaranteed the loan).
This makes lenders feel more secure that they will receive repayment on the loan since the borrower is putting their own personal assets on the line as collateral.
Sometimes lenders don’t require this type of guaranty.
Instead, the property itself is the only means of financial recovery if the borrower defaults on the loan.
This is what is known as a non-recourse loan.
It means that the lender has no recourse against anyone (such as the buyer).
There are three different types of commercial loans:
The right commercial loan for your business will, of course, depend on a number of factors.
These include the amount of time you need to repay the loan, and whether you need a loan to buy an investment / income-producing property, or one to be occupied by your business.
We will examine these types in greater detail later.
But first, let’s review some of the basics of commercial loans.
Commercial Loans – Credit Score & Personal Finance Requirements
Small business owners requesting a commercial loan need to be aware that their individual credit score and personal net worth may also be put under the microscope by potential lenders.
That’s because banks typically want to see a personal credit score for loans that are less than $3 million.
Meanwhile, the minimum credit score that banks are looking for is 680.
If you have a credit rating of 700 or higher, that improves your odds of qualifying for the loan.
In addition to your credit score, banks will also be carefully examining your credit history.
They will be looking to make sure you don’t have any recent:
- Tax liens.
Even if you don’t tick all the boxes that lenders are looking for, there are other factors that can sometimes tip the scales in your favor.
For example, if you have a high personal net worth, that can help you obtain a loan that you might otherwise not be approved for.
In the cases of business owners who want to purchase an investment property, if they can show lenders that they already have a major tenant lined up, such as an established national retailer, they may be able to get approved for a loan that they might otherwise not qualify for.
On the flip side, if you want to buy a vacant strip mall and don’t have any tenants already lined up, this might make lenders nervous and less likely to approve the loan.
This is because they would be gambling on your ability to line up enough tenants in time to cover your loan payments.
On the plus side, if you are seeking a loan for $3 million or more, lenders won’t really care about your personal net worth and credit scores.
Instead, they will be more interested in the property itself, who the tenants will be, and the track record of the business entity that is requesting the loan (i.e., your business credit score.)
Important Things to Remember for Commercial Real Estate Loans
When filling out your request for a commercial loan, it’s important that you take your time and fill it out accurately and completely.
Taking on the debt of a commercial loan is a major financial commitment, and you want to demonstrate to potential lenders that you take that responsibility seriously.
You want to make a good first impression on lenders, and a carefully completed request can demonstrate that you are someone who is trustworthy and reliable.
On the other hand, if you turn in a request that is sloppy or missing information, potential lenders may see you as someone without good attention to detail, and they may be less likely to have faith in your ability to run a business – and to repay your debt.
Remember, you are asking lenders to trust you with a great deal of money.
If you can’t fill out a location request properly, it may make you appear less trustworthy.
You’ll Need a Business Plan
OK, let’s say you know you have impeccable credit, and you dotted all the i’s and crossed all the t’s on your loan request.
But you’re not done yet.
No matter if you are buying the property for your business to occupy, or as an investment property, you need to be ready to prove to potential lenders that you will be able to meet all of your financial obligations – including the loan payments.
This means you need to walk into meetings with lenders armed with a business plan that includes financial projects for the next three to five years.
If you are seeking a loan to buy an investment or income-producing property, you will need to include:
- A description of the property you wish to buy.
- An overview of the market.
- A detailed explanation of how you plan to attract and retain tenants.
If you are requesting a loan to purchase a property for your business to occupy, you first need to demonstrate that your business will continue to be profitable.
You then need to explain how the purchase of this commercial real estate will further improve your financial outlook.
Some potential items you might include in your business plan include explanations of how:
- Your business will save money by making lower monthly loan payments instead of paying to lease your space.
- Purchasing your own building will give you the ability to expand and grow your business.
Anything you can think of that demonstrates that you are a low financial risk should go in your business plan.
If you don’t intend to use all the space for your business’ use, be sure to detail if you intend to generate extra income, for example, by renting out any excess space.
If you will be renting out any of the commercial property to other tenants, your business plan should also include what’s known as a real estate pro forma, a financials projection for the real estate alone.
Most pro formas typically assume a fixed amount of rental income as well as a fixed percentage of vacancies.
They also typically include forecasts for lease renewals, leasing commissions, and tenant improvements.
Finally, you will need to include rent rolls that show how much rent each tenant is paying, and when their lease expires, if applicable.
Repaying Commercial Loans
As we already mentioned, commercial loans tend to have shorter repayment terms than a residential mortgage.
The repayment terms for a commercial loan tend to range from 5 to 20 years, with some for even shorter time periods.
The amortization period (the length of time in which you are making scheduled payments) is typically longer than the actual term of the loan.
Residential loans typically include terms in which the borrower agrees to repay the loan over a fixed amount of years, such as 30 years.
On the other hand, when it comes to commercial loans the borrower needs to consider the term of the mortgage carefully.
Specifically, commercial borrowers need to look at the amortization of the loan – which is needed to calculate the monthly payment that will be owed.
The borrower also needs to take the balloon payment into consideration.
The balloon payment is normally the final payment that’s made on a commercial mortgage loan.
When it’s due, borrowers can either pay the remaining balance in full, refinance, or sell the property.
For example, a lender might make a commercial loan that is 10 years in length but has an amortization period of 30 years.
This means the borrower would make monthly payments for 10 years, but the payment amounts would be calculated as if the loan was really being paid off over the course of 30 years.
That means at the end of the 10 years, one final balloon payment would be due for the remaining balance of the loan.
The interest rate charged by lenders will be affected by both the length of the term of the loan, and the amortization period.
Borrowers with better credit will be able to negotiate better terms and rates.
However, generally speaking, the longer the loan repayment schedule is, the higher the interest rate will be.
How Loan to Value Ratios Are Different for Commercial Loans
We’ve seen that commercial loans are quite similar to residential loans, but another way they differ is when it comes to the loan to value ratio (LTV).
What is loan to value?
The LTV measures the value of a loan against the value of the property.
In order to calculate the loan to value ratio, a lender divides the amount of the loan by whichever number is lower: the property’s appraised value, or its purchase price.
Borrowers who have a lower LTV typically qualify for better financing rates than borrowers who have a higher LTV.
This is because a borrower with a lower loan to value has more equity in the property.
From the point of view of the lender, this means they are less of a risk.
Residential mortgages typically allow for higher LTVs.
For example, LTVs of up to 95 percent are allowed for conventional loans, and LTVs of 100 percent are allowed for USDA loans.
In comparison, loan to value ratios for commercial loans typically fall within the range of 65 to 80 percent.
Occasionally there are commercial loans made at a higher LTV, but that is not the norm.
The specific LTV required may depend on the type of commercial loan.
For example, if a borrower is seeking a loan to purchase commercial land, a maximum loan to value ratio of 65 percent may be allowed.
However, an LTV of up to 80 percent may be allowed for the construction of a multifamily unit.
It’s worth noting that, unlike residential mortgages, there is no private mortgage insurance (PMI).
This means that lenders instead must rely on the property itself as security, which may explain strict lending criteria.
What is Debt-Service Coverage Ratio and Why Does it Matter?
When deciding whether or not to make a loan, many commercial lenders will want to look at the property’s debt-service coverage ratio (DSCR).
This compares a property’s annual net operating income (NOI) to its annual mortgage debt service (including principal and interest).
NOI is basically your profits before you make any loan payments.
The higher your NOI, the better.
This compares a property’s annual net operating income (NOI) to its annual mortgage debt service (including principal and interest).
NOI is basically your profits before you make any loan payments. The higher your NOI, the better.
The DSCR measures the borrower’s ability to make payments on a commercial property loan after they cover their other expenses.
It is calculated by dividing the NOI by the annual debt service.
By looking at the ratio, lenders are able to determine the maximum loan size they are willing to make by first looking at the cash flow generated by the property.
A DSCR of 1.0 means that your business is able to cover all the business expenses and make the loan payment.
However, there is no margin for error.
Meaning if an unforeseen expense comes up, or you experience a drop in revenue, you will come up short on cash – potentially leading to you defaulting on the loan.
This is why most lenders will typically want prospective borrowers to have a DSCR of at least 1.25.
Sometimes a lower DSCR might be viewed as acceptable for loans with shorter amortization periods, or for a property with proven stable cash flow.
On the flip side, lenders may require higher ratios for properties that may have less reliable cash flow, such as a hotel.
This is because these properties lack the predictability that comes with having a long-term tenant such as, say, a doctor’s office.
For owner-occupied real estate, DSCR will primarily be a measure of your gross revenue minus your total operating expenses.
In cases where you will have some excess space to rent out to other tenants, projected rental income can be added to your DSCR calculation.
Commercial Loans Rates and Fees
Another difference between residential vs commercial loans is when it comes to interest rates.
Commercial loans will normally have a higher interest rate than a residential loan, and they often come with added fees that can add to the overall cost of the loan, such as:
- Appraisal fees.
- Legal fees.
- Loan application fees.
- Loan origination fees.
- Survey fees.
In some cases, these costs need to be paid up front – even before the loan has been approved or rejected.
Other fees may be recurring and you will need to budget for them annually.
Why Prepayment May Cost You
Lenders earn money through the interest borrowers pay during the course of the loan.
If you pay the loan off sooner than anticipated, this can impact how much interest a lender earns.
This is why some commercial loans come with restrictions on prepayments – to ensure that lenders receive their anticipated yield on a loan.
If a small business owner repays a loan before it’s maturity date, they will likely have to pay prepayment penalties.
There are four primary types of “exit” penalties that lenders can assess for paying off a loan early:
- Prepayment Penalty. This is the most basic of prepayment penalties. It is calculated by multiplying the current outstanding balance by a specified prepayment penalty.
- Interest Guarantee. This ensures that the lender will receive a specified amount of interest, even if the loan is paid off early. For example, a loan may have a 12 percent interest rate guaranteed for 60 months, with a 5 percent exit fee after that.
- Lockout. A lockout means that a borrower cannot pay off the loan before a specified period, which preserves the lender’s ability to earn all anticipated interest for the loan.
- Defeasance. This is a substitution of collateral. Instead of paying cash to the lender, the borrower exchanges new collateral for the original loan collateral. Borrowers should be aware that high penalties can be attached to this method of paying off a loan.
Prepayment terms and penalties can be negotiated the same as any other terms in your commercial real estate loan.
Make sure you evaluate your options ahead of time so you know what penalties may be assessed against your business if you decide to pay off the loan early.
Traditional Commercial Mortgage
A traditional commercial mortgage is used to purchase non-owner occupied commercial property.
The terms of the loan can be anywhere from five to 25 years, and commercial loan rates are normally variable – ranging from 4.5% to 7.5%.
Depending on the terms of the loan, there may also be a balloon payment due at the end.
Business owners will typically need to meet the following requirements in order to qualify for a traditional commercial mortgage:
- Credit score of at least 680.
- No recent bankruptcies, foreclosures, or tax liens
- A down payment of at least 10 percent.
- Have been in business at least three years.
There are always exceptions, especially for business owners with a high net worth.
However, these are typically the minimum requirements that the majority of commercial real estate lenders will look for.
Commercial Loans for Owner-Occupied Property
If you want to take out a commercial loan to buy property, and you intend for your business to occupy at least 51 percent of the property, your business should be eligible for a Small Business Administration (SBA) loan.
Technically, the SBA doesn’t actually lend the money – banks and other lenders do.
However, the lenders need to adhere to the SBA’s guidelines. The SBA also guarantees a portion of the loan.
These types of loans are beneficial for small business owners because they can offer better rates and longer terms than a traditional commercial mortgage.
Business owners who might be turned down by a traditional lender because of a lack of collateral or a low personal net worth are often able to qualify for an SBA loan.
Let’s take a look at the two types of SBA commercial real estate loans, long-term SBA 7(a) loans, and CDC / SBA 504 loans.
SBA 7(a) Commercial Loans
An SBA 7(a) loan functions much like a commercial business loan you might get at a bank but with one important difference – it comes with the SBA guarantee.
In order to get that guarantee, the lender needs to make sure that your business and your intended use of the borrowed money meet the standards set forth by the SBA.
A long-term SBA 7(a) commercial real estate loan can be used either to purchase an office building or other space for your business.
It can also be used to refinance an existing commercial mortgage – unless that mortgage is also an SBA-guaranteed loan.
If your business is approved for the loan, you are responsible for making payments on the loan to the lender – not the SBA.
Business owners can borrow up to $5 million, and the rates typically run between 5% to 6.25%.
The SBA also sets a maximum rate of 2.75% above prime, and borrowers have up to 25 years to pay the loan off.
Borrowers also are expected to make a down payment of at least 15 percent of the purchase price.
There are a variety of lenders business owners can choose from when it comes to SBA 7(a) loans, including:
- Large, national banks.
- Smaller, community banks.
- Credit unions.
- Community development corporations.
The type of lender you should approach for your commercial loan will depend on the amount of money you need to borrow.
For example, if you need to borrow over $1 million, it’s probably better to work with a national lender instead of your local credit union.
And on the flip side, if you only need to borrow $300,000, it’s probably better to work with a local bank versus a major national bank.
CDC / SBA 504 Commercial Loans
Much like a SBA 7(a) loan, a CDC / SBA 504 loan is for business owners who intend to occupy at least 51 percent of the commercial property they are purchasing.
However, it also allows business owners to spend some of the loan amount to purchase business equipment.
These types of loans work a little differently than SBA 7(a) loans.
The business owners is required to make a cash down payment that will cover at least 10 percent of the cost of the project.
Then, the loan is actually broken down into two parts:
- A commercial mortgage is made by a traditional lender, such as a bank or credit union, for up to half of the cost of the total project.
- The second mortgage is from a community development corporation (CDC) for up to 40 percent of the cost of the project.
A CDC / SBA 504 loan can be an appealing choice for small business owners due to their low rates, which are typically lower than SBA 7(a) loans.
However, there are several disadvantages to be aware of as well.
The maximum term for a CDC / SBA 504 loan is 20 years, in comparison to 25 years for a SBA 7(a) loan.
The mortgage that is held by the bank will also typically have an interest rate reset at the five-year mark, and a balloon payment that is due 10 years into the life of the loan.
That means once you are halfway done paying your loan you need to either be ready to pay a significant amount of money at once, or refinance the balloon payment.
Depending on where interest rates are at the time, this could result in significantly higher costs than you may have anticipated.
Another downside to CDC / SBA 504 loans is the amount of time and effort it takes to coordinate everything between your business, the seller, the bank, CDC, and SBA.
Not to mention you will have higher standards to meet than for a SBA 7(a) loan.
Unless you really need to combine your purchase of commercial real estate and equipment, it might be better to pursue other loan options.
Whether you need a loan to buy property to start a business, grow a business, or as an investment property, chances are there may be a lender with a commercial loan available to meet your needs.