Commercial Real Estate Loans vs. Mortgage, Where to Start
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Your vision is to move into a commercial building.
You're expanding from a home office or other location and you’re not quite sure what to expect when it comes to getting a loan. Do you go to a bank and get a mortgage as you did for your home? No, you need a commercial real estate loan. This article walks you through where to get one, the types, how these differ from mortgages, fees, and what to watch for.
How do you know if you need a commercial real estate loan?
These types of loans are to purchase or renovate business or commercial properties that are owner-occupied, which means that 51% of the property has to house that business. If the property is to generate money, then it falls in this category of loan.
What types of buildings are commercial?
Examples are retail centers, shopping centers, warehouses, apartment complexes, storage facilities, car washes, office buildings, mixed-use buildings, and any other related building type.
Where do you get a commercial real estate loan?
If you do a Google search, you will find a lot of side-by-side comparisons of rates, requirements, and such like this. There are links below to the types of loans that could be a start in your search.
The positive to these types of loans are that you have a lot of options, there are a lot of different terms, they can make it flexible to repay, you get tax breaks, and you will have equity.
The negatives to these types of loans are the barrier to entry can be high, the approval time can be long, lenders view these ask riskier, and therefore higher interest and upfront costs for you. Like personal loans, the better your credit, the better your rates will be on these.
What types of business loans would you choose from?
There are six basic loan types that you may qualify for and you can search for based on which fits your situation based.
- Permanent loan: This is like a mortgage, it’s longer-term like 5 years or more. Think of it as the first mortgage on the property
- SBA loan: These are the U.S. Small Business Administration loans, and there are two programs, one is SBA 7(a) and the other SBA 504. 7a gives you flexibility in how you use the money you will need a down payment of at least 10%. The 504 also requires around 10% and the money has to be used on real estate, machinery, or renovations, which may require you have experience in management and a logical business plan.
- Bridge loan: These are shorter-term options, one year or less and they have a high-interest rate. The idea is you use this quickly while you are waiting on longer-term solutions.
- Line of credit: These are revolving loans that allow you access to a fixed amount of money that can be used for short-term needs.
- Hard money loan: This is based on assets secured by property and is usually from private investors and requires less proof that the loan can be paid. It’s somewhat challenging to get and likely a higher interest rate of 7 to 8%
- Blanket loan: This would be used for multiple properties and they are all tied together with this so if one doesn’t do well, it can affect all.
What is different for commercial real estate loans vs. traditional mortgages?
When you are seeking a loan for a commercial purpose, it’s different from a mortgage, and it’s a commercial real estate loan and with that are some different terms and requirements to be aware of.
Who the loan is made to
You instead are loaned a chunk of money to invest in your business and purchase the property, however, this is generally made to the entity like a corporation, limited partnership, fund, trust, etc.
Commercial Interest rates
Interest rates for these loans are set by the prime rate, or what banks charge for short and medium-term credit and are typically higher than a loan for your house.
Note that you may see something like “Prime + 1.2” and that means you would be paying 1.2% above whatever the prime is. Technically, banks can choose their own prime rate, but most base it off of the 30 largest banks, which use the Federal Funds Target Rate. In short, most banks go by the standard set of the largest banks, so they are going to be fairly aligned.
The term
The term on these loans is shorter than 30 years on a typical house. They are usually 3 years, with a maximum of 10, sometimes 20 years.
Collateral or insurance
You will need collateral so that the bank is insured you can pay the loan back. When you mortgage a house, it’s your house that is the insurance, but for a business loan, you will need other things that are of value in case of default. This could be stocks, bonds, or real estate if you don’t have a track record of credit.
The process
The process to get the loan will require more documentation than a typical mortgage. I recommend checking out the U.S. Small Business Administration’s Loan Programs if you are actively looking.
Loan-to-Value Ratio (LTV)
This is lower than a home loan and it’s the value of the loan compared to property value, or loan amount divided by property value.
Let’s say your loan is $100,000 and the property is $110,000, that would be 91%. That sounds great, right? It’s actually not for the lender because they would rather have more equity which is less risky so actually, these types of loans are usually in the 65% to 80% range.
Debt-Service Coverage Ratio (DSCR)
This is comparing the annual net operating income or NOI of the property to the annual mortgage debt service. This means they look at the ability of the property to service the debt or generate the cash to actually pay the debt.
Let’s say your property has an NOI of $150,000 and the loan was $100,000, so your DSCR is 1.5. This is great because 1.25 is required to say that the property can cover the cash flow needed. If you are less than one, that would mean a negative cash flow and it’s not generating enough cash to cover the loan. There are exceptions depending on the type of business, but in general, this is a guide.
Commercial Loan Fees
- Origination fee: You may see something like a 1% origination fee on your loan. This would be paid at closing and it’s one-time.
- Annual fees. Sometimes you will see an annual fee of something like .25% until the loan is paid off so that’s something else to consider being added to your annual total spend.
- Guaranty fee: You will likely find this on an SBA loan, and it could be up to 3.75% for example of the guaranteed portion of the loan.
If you want to pay the loan early, look for these
This is where you can get some surprises so make sure to look into the details.
Prepayment penalty: This is fairly common with these types of loans and it will be specified in your paperwork so check that out before signing if you assumed you would be able to pay it off early.
Interest guarantee: The lender can get their 8% interest for the length of the term so if you pay it off early, you might see something like a 5% exit fee.
Lockout: You may not be able to pay the loan off before a certain time limit like 3 years.
Defeasance: This is something to use instead of collateral in order to pay back and to cut down on the fees, but usually, there are worse penalties.
In summary, this is a high-level view of items to be aware of and familiar with along with some places and resources for commercial business loan information. If you have tips or additional resources for getting these various loans, please comment!
Written by Nicole Hullihen, October 24th, 2021
References to learn more about commercial real estate loans
https://www.investopedia.com/mortgage/mortgage-rates/how-it-works/
https://www.tmcfinancing.com/commercial-real-estate-loan-rates-how-are-they-determined/
https://www.sba.gov/partners/lenders/cdc504-loan-program/operate-cdc
https://www.investopedia.com/articles/personal-finance/100314/commercial-real-estate-loans.asp
https://www.business.org/finance/loans/commercial-real-estate-loans/
https://www.nav.com/business-financing-options/commercial-real-estate-loans/
https://www.intrepidexecutivegroup.com/blog/hard-money-vs-soft-money-whats-difference/
https://www.goamplify.com/blog/business/types-commercial-real-estate-loans/