Business real estate loan (CRE) is a real estate that generates income and is used exclusively for business loan purposes such as shopping centers, office complexes, hotels and apartments. Financing – including the acquisition, development and construction of these properties – is usually achieved through commercial property loans: mortgage loans secured by liens on commercial, rather than residential, property.
Just as with home loans, banks and independent lenders are actively involved in providing loans to commercial real estate. Insurance companies, pension funds, private investors and other sources of capital, including the US Small Business Administration’s 504 loan program, also provide loans for commercial real estate.
Here we look at commercial real estate loans: how they differ from home loans, their characteristics and what lenders are looking for.
Individuals versus entities
Although home mortgages are usually made for individual borrowers, commercial property loans are often provided to business entities (eg, companies, developers, partnerships, funds, and trusts). These entities are often formed for the specific purpose of owning commercial real estate.
An entity may not have a financial record or credit history, in which case the lender may ask the principals or owners of the entity to guarantee the loan. This provides the lender with an individual person (or group of individuals) with a credit history and / or financial record – and from whom they can recover in the event of a loan default. If this type of guarantee is not required by the lender and ownership is the only means of restoring in the event of default, the loan is referred to as a non-recourse loan, meaning that the lender cannot take redress against anyone or anything other than ownership.
Loan repayment schedules
A home mortgage is a type of written off loan where the debt is repaid in regular installments over a certain period. The most popular residential mortgage product is the 30-year fixed-rate mortgage.
Home buyers also have other options, including 25-year and 15-year mortgages. Longer depreciation periods generally relate to smaller monthly payments and higher total interest costs during the term of the loan, while shorter depreciation periods generally entail larger monthly payments and lower total interest costs. Residential loans are amortized over the term of the loan, so that the loan is fully repaid at the end of the term of the loan. For example, a 200-year borrower with a 30-year interest rate at 5% would make 360 monthly payments of $ 1,073,664, after which the loan would be fully repaid.
Unlike with home loans, the conditions for business loans generally vary from five years (or shorter) to twenty years and the repayment period is often longer than the term of the loan. For example, a lender can take out a commercial loan for a term of seven years with a repayment period of 30 years. In this situation, the investor would make payments for seven years based on the fact that the loan will be repaid in 30 years, followed by a final “balloon” payment of the remaining balance of the loan. For example, an investor with a commercial loan of $ 1 million at 7% would pay $ 6, 653.02 for seven years, followed by a final payout of $ 918, 127.64 that would pay off the loan in full.
The duration of the loan period and the depreciation period affect the rate that the lender charges. Depending on the creditworthiness of the investor, these terms and conditions may be negotiable. In general: the longer the loan repayment schedule, the higher the interest.
Another way in which commercial and home loans differ is the loan-to-value ratio (LTV): a figure that measures the value of a loan with the value of the property. A lender calculates LTV by dividing the loan amount by the lowest of the appraised value or purchase price of the home. For example, the LTV for a $ 90,000 loan on a property of $ 100,000 is 90% ($ 90,000 ÷ $ 100,000 = 0. 9, or 90%).
For both business loan and residential mortgages, borrowers with lower LTVs are eligible for more favorable financing rates than those with higher LTVs. The reason: they have more equity (or interest) in the building, which in the eyes of the lender equals less risk.
High LTVs are permitted for certain home mortgages: up to 100% LTV is permitted for VA and USDA loans; up to 96.5% for FHA loans (loans insured by the Federal Housing Administration); and up to 95% for conventional loans (those guaranteed by Fannie Mae or Freddie Mac).
LTVs for commercial loans, on the other hand, are generally in the range of 65% to 80%. Although some loans can be provided with higher LTVs, they are less common. The specific LTV often depends on the loan category. For example, a maximum LTV of 65% may be allowed for unprocessed land, while an LTV of up to 80% may be acceptable for a multi-family construction. There are no VA or FHA programs for commercial loans and no private mortgage insurance. Therefore, lenders do not have insurance to hold the borrower in default and they must rely on the property pledged as collateral.
Note: Private Mortgage Insurance (PMI) is a type of insurance policy that protects lenders against the risk of default and foreclosure, allowing buyers who cannot make a significant down payment (or choose not to) make mortgage financing at affordable prices. If a borrower buys a property and earns less than 20% less, the lender minimizes his risk by requiring the borrower to purchase insurance from a PMI company. See How to get rid of private mortgage insurance .
Debt service coverage ratio
Commercial lenders also look at the debt service coverage ratio (DSCR), which compares the annual net operating result (NOI) of a home with its annual mortgage debt (including principal and interest), to measure the property’s ability to pay its debts. It is calculated by dividing the NOI by the annual debt service. For example, a home with $ 140,000 in NOI and $ 100,000 in annual mortgage debt service would have a DSCR of 1.40 ($ 140,000 ÷ $ 100,000 = 1.4). The ratio helps lenders determine the maximum loan based on the cash flow generated by the home.
A DSCR of less than 1 indicates a negative cash flow. For example a DSCR of. 92 means that there is only enough NOI to cover 92% of the annual debt service. In general, commercial lenders are looking for DSCRs of at least 1.25 to guarantee an adequate cash flow. A lower DSCR may be acceptable for loans with shorter depreciation periods and / or buildings with stable cash flows. Higher ratios may be required for properties with volatile cash flows, for example hotels, that lack the long-term (and therefore more predictable) leases of other types of commercial property.
Interest rates and fees
The interest rates on business loans are generally higher than on home loans. Commercial real estate loans are also usually accompanied by fees that contribute to the total costs of the loan, including appraisal, legal loan, loan application, loan build-up and / or assessment costs. Some costs must be paid in advance before the loan is approved (or rejected), while others are applied annually. For example, a loan can have a one-off loan premium of 1%, payable at the time of taking out, and an annual fee of a quarter of a percent (0.25%) until the loan is fully paid. A $ 1 million loan, for example, may require a 1% loan, equivalent to $ 10,000, to be paid in advance, with a fee of $ 25,000, $ 25 paid annually (in addition to interest).
A commercial real estate loan can have prepayment restrictions designed to preserve the expected proceeds from a loan by the lender. If investors settle a debt before the maturity date of the loan, they will probably have to pay Sam Spadeijk early repayment penalties. There are four primary types of “exit” fines for early repayment of a loan:
Prepayment penalty . This is the most basic prepayment penalty, calculated by multiplying the current outstanding balance by a specific prepayment penalty.
Interest guarantee . The lender is entitled to a certain amount of interest, even if the loan is paid off early. For example, a loan can have a guaranteed interest rate of 10% for 60 months, followed by an exit fee of 5%.
Lockout . The borrower cannot pay off the loan before a certain period, such as a lock-out of 5 years.
split off . A substitute for collateral. Instead of paying cash to the lender, the borrower exchanges new collateral (usually treasury paper) for the original collateral of the loan. High fines can be linked to this method of paying off a loan.
Advance payment conditions are identified in the loan documents and can be negotiated together with other loan conditions in commercial real estate loans. Options must be understood in advance and assessed before a loan is paid off early.
The bottom line
With commercial real estate, it is usually an investor (often a business entity) who buys the property, rents space and rents rent from the companies that are active in the property: the investment is intended to be a revenue-producing property.
When evaluating commercial real estate loans, lenders consider the collateral of the loan; the creditworthiness of the entity (or clients / owners), including three to five years of financial statements and income tax returns; and financial ratios, such as the loan-to-value ratio and the debt-service coverage ratio. For more information, read 7 steps to a hot commercial real estate listing and search for a fortune with commercial real estate .