What is a Commercial Real Estate Loan?
Commercial real estate, as you might’ve guessed, is real estate that’s used only for business uses. So if you manage your small business through a office space or retail store, you’re working out of commercial real estate.
If you are planning to purchase new or existing commercial properties, you can take out a commercial real estate loan to help finance the purchase—and any development or construction after the fact.
Commercial real estate loans are typically options for certain business entities, like a limited liability company. All this is to say that businesses take out a commercial real estate loan.
How Does a Commercial Real Estate Loan Work?
So, commercial real estate loans help you pay for the sky-high price tags that come attached to your new property. How do they work? Commercial real estate loans are mortgage loans secured by liens on the commercial real estate you’re purchasing rather than on residential property.
Let’s take a step back. What’s a lien? Well, in this specific case, a lien is a legal right that an owner of a property gives to a creditor, serving as a guarantee for the repayment of a commercial real estate loan. If the owner can’t pay back the debt, that credit might be able to seize the asset secured by a lien. A lien just gives your commercial real estate lender some protection against the risk that you default on your loan and can’t pay them back.
When you take out a commercial real estate loan, you should absolutely expect to have a lien put on at least your business report. But you should be ready to make a down payment on your commercial real estate loan.
Before funding your loan, the majority of lenders will typically require a down payment between 20 and 30% of the property’s purchase price. Now for the nuts and bolts of a commercial real estate loan: repayment terms, interest rates, and fees.
Repayment Term and Schedule
Think of your average residential mortgage like the one you might have on your home. A normal residential mortgage is a type of amortized loan, where you pay your debt in regular installments over a fixed period of time, say 30 years. A commercial real estate loan come with two types of terms: intermediate-term loans of 3 years or less and long-term loans that last for 5 to 20 years. A commercial real estate loan may also come as an amortized loan or as a balloon loan. An amortized loan is paid off in fixed installments until you’ve fully paid the lender back, plus interest. A balloon loan requires you to make one big payment at the end in order to pay off your remaining principal.
When you take out a balloon commercial real estate loan, your given term for repayment typically ranges from 4 to 4 years. You’ll have fixed monthly payments through that term, but those payments aren’t set up to cover the entire repayment. Instead, the monthly payments are measured as if the loan is a traditional 25 to 30 year mortgage like a residential mortgage. At the end of your 4 to 6 year term, you would have paid off only a portion of your principal balance.
If you’re considering the balloon loan option, know this: that last payment could be very high. You should really only sign on the dotted line for a balloon loan if you know you’ll have the cash on hand when it comes time to make the final payment. you’ll have to refinance your loan or sell your business property to make the balloon payment if you don’t repay it.
As with any commercial loan, the actual interest rate you get on your commercial real estate loan depends on your type of business, its financial health, and your creditworthiness.
But in general, commercial real estate loans tend to come at a steeper interest rate than a residential mortgage would. Businesses are just risky to lend to, especially if you’re a start up. Plus, most businesses have less established credit histories than individuals.
Your interest rate will also depend on your loan-to-value (LTV) ratio. An LTV ratio measures the value of a loan against the value of the property purchased.
Say you’re purchasing a $100,000 piece of property. Commercial real estate lenders typically require borrowers to put a down payment of about 20 to 30% of the purchase price. So, you’ve covered a little portion of the cost and the lender is covering the rest of it by extending the loan. In this case, the loan ratio is 70 to 80%.
Here’s where your interest rate comes in. If you have a high LTV, you’ll likely have a higher interest rate. So they have more to lose if you default on your commercial real estate loan. Although, if you’ve paid more of the purchase price in the form of a down payment—and you have a lower LTV—you’ll have a lower interest rate on your loan.
On top of interest rates, commercial real estate loans will come with fees. Most commercial real estate loans have upfront fees that you’ll need to pay.
Upfront fees are bundled into the overall cost of the loan—covering the property legal costs, appraisal, loan application, survey fees and loan origination,. Some commercial real estate lenders will want borrowers to pay upfront fees before the loan is approved.
You should also be aware of fees associated with paying your commercial real estate loan off early. You might have a typical payment penalty but there could also be an interest guarantee or just a lockout barring you from paying early. A lender wants to preserve their anticipated gain on a loan, so they might charge you for paying early.
Before you commit to your commercial real estate loan, always ask the lender to clearly explain any and all fees that will be a part of your total cost of borrowing. You wouldn’t want to be hit with hidden fees down the line.
What to expect when applying for a Commercial Real Estate Loan
You’ll need to get your financial ducks in order first. Commercial lenders tend to have a more rigorous underwriting process than residential loans do. With commercial real estate loans, having a clear and detailed business plan is crucial. Lenders will not only scrutinize your project, but they’ll also carefully consider the property you intend to buy and your plans for using it. Make sure you spell all of this out in your business plan.
Depending on the size of the commercial loan, you’ll also need to prove your business’s financial strength. Be prepared to submit 4 to 6 years worth of financial documents, tax returns, like your asset statements, corporate accounting reports, and any other relevant information. You’ll also need to show your personal financial information and personal credit history.