Commercial real estate (CRE) loans differ from residential loans in some important ways. Obtaining commercial real estate financing can be a complex process and overwhelming for some small business owners who may not be prepared.
At Addition Financial, we value our business members and we’re here to help them navigate the process of obtaining the financing they need. They often come to us with questions about how to get a commercial real estate loan. With that in mind, this post will provide an overview of commercial real estate loans plus eight steps to apply for and get the money you need.
How Do Commercial Real Estate Loans Work?
Commercial real estate loans are loans that may be used only to purchase commercial real estate. According to the FDIC, loans may be used for the acquisition of commercial property and/or its development, as well as for construction financing.
As a commercial real estate lender, we provide commercial mortgage loans to businesses. The primary restriction on the use of loan funds is that the property must be used for business purposes. In other words, you cannot obtain a commercial real estate loan to buy your personal residence.
Here are some types of property that are classified as commercial real estate and may be purchased, developed or built with a commercial real estate loan:
- Office buildings
- Retail sales buildings
- Storage facilities/warehouses
- Medical facilities
- Restaurants
- Raw land
- Parks or recreational facilities
- Housing developments
- Apartment buildings
It is rare for a business to be able to afford the purchase of commercial property without the backing of a lender since these properties are often significantly more expensive than residential properties.
What Are the Differences Between Residential and Commercial Real Estate Loans?
As noted above, the biggest difference between residential and commercial mortgages is that a commercial mortgage may only be used to buy commercial property, while a residential loan may only be used to purchase a property intended for personal use.
Another significant difference between commercial loans and residential loans is that commercial loans tend to have shorter amortization periods than residential loans. The most common amortization period for a residential mortgage loan is 30 years, which is also usually the term of the loan. What that means is that you will pay off your loan at the same rate that it amortizes, so when you make your final monthly payment, your loan will be paid off.
Commercial loans come with a shorter term and an amortization period that often doesn’t align with the term. For example, you might have a commercial property loan with a loan term of 15 years. However, the loan will still amortize over 30 years. When you make your final payment at the end of the 15-year term, you will also be responsible for a balloon payment. The balloon payment pays for the remaining amortization.
Is There More Than One Type of Commercial Real Estate Loan?
If you are planning to purchase commercial real estate, you should know that there are several types of loans that may be available to you.
- Ordinary Commercial Real Estate Loan. An ordinary CRE loan has a lot in common with a typical residential mortgage. It’s a secured loan that’s backed either by the property being purchased or by alternative collateral, such as business equipment or another property that’s owned by the business.
- SBA Loan. Small Business Administration real estate loans fall under multiple programs and offer some advantages because the SBA guarantees a portion of the money being borrowed. The rates may be lower than they would with an ordinary loan.
- Bridge Loans. Bridge loans are short-term loans that are sometimes used by property developers. Their purpose is to provide the developer with short-term financing to build on a property and sell it, usually within six months to two years of the purchase. Bridge loans are a popular choice for property flippers, as well.
- Seller-Financed Loans. In some cases, the seller of a property may be willing to finance a commercial loan, something that happens most frequently with income-producing property such as apartment buildings or retail space. The big advantage with seller-financed loans is that the interest rate may be lower than what you could get from a credit union or bank.
The type of loan you choose will depend upon your needs and the nature of the property being purchased.
What Does It Take to Qualify for a Commercial Real Estate Loan?
The high failure rate for small businesses – 50% of new businesses fail within the first five years of being established according to the Bureau of Labor Statistics – means that lenders who provide CRE loans are taking a risk to provide these loans. It’s for that reason that the requirements are strict.
While underwriting standards may vary slightly from lender to lender, here are the requirements that you should expect to meet when you apply for a commercial real estate loan:
- Business structure. A loan to a sole proprietorship would be the same as a personal loan; to qualify for commercial lending, your company must be structured as a business entity. Examples include an LLC or an S corporation.
- Business credit score. Most lenders use the FICO Small Business Scoring Service (SBSS) credit score to evaluate commercial loan applications. You’ll need a minimum score of 155 to qualify with most lenders although there are exceptions.
- Personal credit score. It’s common for small business owners to sign a personal guarantee for the loan. If you’re backing your commercial loan with your home or personal credit, you’ll need a FICO score of 660 or higher.
- Use of purchased property. If you are buying an existing property, your company must occupy at least 51% of the structure to qualify for a CRE loan.
- Down payment. Just as you would with a residential mortgage, you’ll need to make a down payment toward any commercial property you buy. Most lenders will require a minimum of 20% as a down payment because most CRE loans have a loan-to-value ratio of 65% to 80%.
- Debt-service coverage ratio. The DSCR compares the net operating income of the property to its annual mortgage debt service and it provides lenders with the means to evaluate the property’s ability to service the debt payments. You can calculate your DSCR by dividing your net operating income by the debt service; the DSCR should be 1.0 to qualify but some lenders prefer a DSCR of 1.25 or above.
If you can meet these six standard requirements, you’ll have a good chance of being approved for the commercial real estate loan you need.
8 Steps to Get a Commercial Real Estate Loan
Now that you know the basic requirements to qualify for a real estate loan, here are eight steps to follow to prepare for your loan application and make the approval process as smooth as possible.
#1: Save for a Down Payment
First, you’ll need to save for a down payment. As we noted above, the minimum down payment for a commercial loan is 20%; if you plan to buy a property that’s selling for $500,000, you will need a down payment of $100,000 or more to qualify.
#2: Improve Your Credit Scores
We always recommend checking your credit reports and scores before applying for a loan. In the case of a commercial loan, you should review both your personal and business credit scores. As we mentioned, your commercial score should be 155 or higher and your personal score should be 660 or higher to qualify.
#3: Shop for Lenders
When it comes to commercial lending, you have choices. We suggest researching multiple lenders to find your best deal. Remember that in many cases, credit union loans come with lower interest rates and more favorable loan terms than bank loans.
#4: Submit Your Application and Documentation
Every loan has an application process. To apply for a CRE loan, you’ll need to complete the application and provide documentation to support it. Here are the documents you’ll need to apply:
- Business tax returns
- Business books and financial records
- Pro forma (an operating budget that should include important financial ratios, including your DCSR, capitalization rate, net operating income and internal rate of return)
- 3+ months of business credit union or bank statements
- A copy of your business plan
- Documents related to your collateral (its value, etc.)
- A third-party appraisal of the property you plan to buy
The lender may require additional documentation, so be sure to provide everything required to avoid delays.
#5: Add a Co-Signer or Investor
Adding someone to co-sign your loan isn’t necessary in every case but it may be necessary if you don’t meet the minimum credit score requirements or if your business is struggling in any way. You may be able to get an investor to co-sign on your loan, particularly if they believe that buying commercial property is the key to them recouping their investment.
#6: Property Appraisal
As part of the underwriting of your loan, your lender will order an appraisal to make sure that the value of the property you’re buying is enough to allow them to recoup their losses in the event that you default on your loan.
#7: Respond to Lender Requests
After you submit your application to your chosen lender, the underwriting process will begin. During this time, you may be contacted by the lender for additional information pertaining to your business and/or loan application. Responding promptly will minimize delays. When underwriting is complete, it’s common for the lender to submit the application for a review by committee before the final approval.
#8: Approval and Closing
The final steps involve getting approved for your loan and scheduling and attending the loan closing. During the closing, you will provide necessary information, including proof of insurance, and sign the loan documents. After that, you can take possession of your new property.
Obtaining a commercial real estate loan requires planning and documentation. Following the steps we’ve explained here will smooth the underwriting process and increase your chances of getting the CRE loan you need for your business.
Are you seeking a business loan to grow your business? Addition Financial can help! Click here to read about our commercial loans and begin the application process today.
Posted on Nov 22, 2022
