Loans come in all shapes and sizes. When you apply for a loan of any type, you should be sure that you understand the loan’s terms and conditions, including what you may use the money to do. Commercial loans have different rules and terms than personal loans.

If you own a business and want to buy property, you’ll need a commercial property loan. At Addition Financial, we help our business members obtain the commercial financing they need to grow their businesses and that includes assisting them with commercial property loans. With that in mind, we’ve created this guide to help you understand the differences between residential and commercial property loans.

What is a Commercial Real Estate Loan?

A commercial real estate loan is a business loan that may be used to purchase property that’s intended for commercial use. The money may be used for the purchase of property or for the development of it or construction on it.

To qualify for a commercial real estate loan, the property must be used for commercial purposes and may not be for personal use. Said another way, a commercial mortgage is to businesses what a residential real estate loan is to individuals and families.

Commercial property loans come with a significant amount of risk for lenders because of the high failure rate of small businesses. According to the Bureau of Labor Statistics, as many as 50% of all businesses fail within their first five years. For that reason, the underwriting process for commercial loans requires documentation of the business’s ability to repay the loan.

Types of Commercial Real Estate Loans

There are several types of commercial real estate loans to consider, including the following:

• An ordinary commercial real estate loan is a secured loan that is backed by collateral. Most frequently, the property being purchased is used as collateral but in some cases, businesses may use other property or equipment to back the loan.
• Small Business Administration (SBA) loans are partially guaranteed by the SBA and if your business qualifies, you may be able to get a lower interest rate than would be possible without the SBA.
• A bridge loan is a short-term loan that’s meant to bridge a gap in financing or to allow a developer to develop property before reselling it.
• A seller-financed loan is financed by the seller of the property and like an SBA loan, may come with lower-than-usual interest rates.

Any of these loans may be used to buy or develop commercial properties.

What Types of Properties Qualify for a Commercial Loan?

Just as there are limitations on what you can purchase with a residential mortgage, there are guidelines that explain which properties may be purchased or developed with a commercial property loan.

The primary consideration is that the property must be intended for commercial use by the business that obtains the loan. Here are some examples of the types of property you could buy with a commercial loan:

• Retail locations
• Office buildings
• Warehouses
• Storage facilities
• Restaurants
• Medical facilities
• Parks or recreation facilities
• Restaurants
• Housing developments
• Apartment buildings
• Raw land (for development)

There are restrictions on the uses of property and we’ll explain those in the next section.

What Are the Requirements for a Commercial Property Loan?

The requirements for commercial property loans are there to help lenders assess prospective borrowers to make sure they have the means to repay the loan. Here are the basic requirements to obtain a commercial real estate loan.

Business Entity

To qualify for a commercial real estate loan, your business must be structured as a business entity. By that we mean that you cannot be operating as a sole proprietorship because a loan granted to a sole proprietor would be a personal loan. Examples of qualifying business entities include LLCs and S corporations.

Credit Scores

Most commercial lenders use the FICO Small Business Scoring Service (SBSS) to evaluate a company’s ability to repay a loan. When you apply for a commercial real estate loan, you’ll need an SBSS score of at least 155 to qualify.

If you intend to sign a personal guarantee for a commercial loan, you should expect the lender to check your personal credit as well. You’ll need a minimum score of 660.

Down Payment

If you’re familiar with residential mortgage loans, you know that while a 20% down payment may be desirable, there are many loan programs that allow people to buy homes with down payments as low as 3%. That’s not the case with commercial real estate loans. You’ll need a minimum 20% down payment; most commercial property loans have a loan-to-value ratio between 65% and 80%.

Debt-Service Coverage Ratio

The debt-service coverage ratio (DSCR) is a ratio that compares the net operating income of the property being purchased to its annual mortgage debt service. You can calculate your DSCR by dividing the net operating income of the property by the debt service. If your DSCR is less than one, it means that the property won’t generate enough income to repay the loan. Many lenders prefer to see a DSCR of 1.25 or higher.

Use of Property

The final requirement for a commercial property loan is that at least 51% of the premises must be used by the business applying for the loan. In other words, you can’t use a commercial loan for a property that your business won’t use.

What Are the Main Differences Between Residential and Commercial Property Loans?

There are three major differences between residential and commercial mortgage loans. Two we have already mentioned and one requires an explanation.

Type of Property Purchased

As we already mentioned, commercial real estate loans may only be used to purchase property intended for commercial use. Examples include office buildings, warehouses and restaurants. A commercial loan may not be used to purchase personal real estate, even if you plan to buy an income-generating property as a personal investment.

Use of Property

Another key characteristic that differentiates commercial property loans from residential loans is that at least 51% of the property bought with the loan must be used for commercial purposes by the borrower. The flip side is that you will be able to rent out some space if you choose to do so, and having renters can help you offset your mortgage payments.

Terms and Amortization

By far the biggest difference between commercial and residential loans is in the terms and amortization.

With a residential loan, the term and amortization period match. By that we mean that if you take out a 30-year mortgage, the loan will amortize at the same rate as the loan term. Each monthly payment will include a combination of interest and principal and when you make your final payment, the loan will be paid off and you take full ownership of the property.

Commercial loans are also amortized over 30 years, but the term of the loan is usually shorter than that: 15 or 20 years is typical. When you make your final payment on a commercial real estate loan, you will also be responsible for a balloon payment to pay off the remainder of the loan. If you decide to get a commercial property loan, you’ll need to plan for that balloon payment.

What Are the Benefits of a Commercial Loan?

Here are some of the advantages of buying commercial property with a commercial real estate loan:

• Equity. When you buy property instead of renting it, you’ll be building equity. It may be possible in the future to borrow against that equity when you need funds to pursue your business growth goals.
• Low interest rates. In many cases, commercial property loans have lower interest rates than residential loans and can make it affordable to buy the property you need.
• Income potential. Since commercial lending guidelines say that 51% of the property needs to be used by your company, you have the potential to rent out some of the space in the property you buy to generate income.
• Capital gains. When you purchase a commercial property, it is a reasonable assumption that you will realize some long-term capital gains as a result of the purchase. Getting a commercial real estate loan can also serve as an investment in your company’s growth potential.
• Security. Renting commercial property can be expensive and comes with some potential risks, including the possibility that you’ll be priced out of renting your location. With a commercial property loan, you’ll have fixed and predictable payments, which can free you up to focus on long-term growth and goals.

These benefits make commercial borrowing a desirable option for many business owners.

Disadvantages of a Commercial Real Estate Loan

In addition to the benefits we’ve mentioned, there are a few potential disadvantages to purchasing a business property with a commercial real estate loan:

• Down payment. As we mentioned earlier, the minimum down payment for a commercial property loan is 20% of the purchase price. It may take a while to raise enough money to purchase commercial property.
• Balloon payment. Many commercial real estate loans come with a balloon payment at the end and paying it may present some financial challenges.
• Property maintenance. When you rent commercial property, any maintenance issues fall to your landlord. When you buy, you’ll be the one handling any problems (and related expenses) that arise with the property.
• Market fluctuations. While the overall trend of real estate prices is an upward trend, there’s still the possibility that the market could experience a downturn at a time that you want to sell, and that could mean you take a loss on the property.

For many businesses, the benefits of commercial property loans outweigh the risks.

Getting a commercial property loan can help you buy commercial property for your business, including office buildings, warehouses, retail spaces and more. We suggest comparing interest rates and terms from multiple lenders before you apply for a loan.

Are you a small business owner seeking a commercial real estate loan to buy property for your business? Addition Financial is here to help. Click here to learn about our business loans and begin the application process now.