Commercial real estate investing (CRE): it can transform your business and skyrocket your wealth.
Commercial real estate investing has longtime been a source of additional wealth for both businesses owners and investors alike.
But new investors or those who have focused on residential real estate may not have considered investing in commercial real estate properties because of perceived risks or the high entry cost.
Once you familiarize yourself with commercial real estate financing basics, though, you’ll likely find that investing in commercial properties is not inaccessible.
Below we’ve created the following guide explaining CRE financing, including how to prepare for the process and different sources to obtain a loan.
What Is Commercial Real Estate Financing?
Financing your commercial real estate purchase, also known as taking out a “CRE loan,” involves taking out a debt-based agreement set up between the borrower and the lender. The lender could be a finical institution or private entity that gives funds to the borrower to obtain a commercial property.
One thing to keep in mind is that a “commercial loan” and a “commercial real estate loan” are not the same things. Commercial loans involve acquiring funds for non-real estate purposes, like purchasing equipment or funding operating expenses.
As an investor, the goal is to secure a real estate loan to pay for your property. You’ll also want to look at institutions that specialize in these kinds of loans.
How does CRE financing work? Here are some basic terms and processes that you should understand.
Important Loan Ratios
To determine your CRE financing, lenders will consider a few ratios: the loan-to-value ratio (LTV) and the debt service coverage ratio (DSCR). It is necessary to understand these ratios because they will determine your finance rates.
The loan-to-value ratio measures the value of the loan against the value of the property. You find the LTV by dividing the amount of the loan by its purchase price. For instance, the LTV for a $150,000 loan on a $200,000 property would be 75%.
Having a lower LTV will qualify you for getter financing rates for your credit loan. With more of your equity in the property, the lender will view you as less of a risk.
The debt service coverage ratio refers to the property’s annual net operating income (NOI) to the annual mortgage debt service. The ratio essentially measures if the property can pay for its own debt.
You find the DSCR by dividing the NOI by the annual debt service. For instance, say your property has $200,000 in revenue and $150,000 in annual debt service. The DSCRB will be 1.25 ($200,000 / $150,000 = 1.25).
A DSCR over 1 means that the property has a positive cash flow. Anything less than 1 (such as a DSCR of .85) means that the property doesn’t have enough net income to cover the annual debt service.
A high DSCR will raise the maximum loan size for the property, which is based on the cash flow.
CRE Loan Repayment Terms
Commercial real estate financing repayment often sees repayment periods between 5 to 20 years. The amortization period is usually longer than the length of the loan.
For example, say you have a commercial loan for a term of 10 years. The amortization period is 30 years, so you would make payments for 10 years based on the loan being paid off over 30 years. Then you would make a final payment of the entire remaining balance on the loan.
The commercial real estate loan term and the amortization period will influence the rate that the lender charges you. Your credit score may allow you to negotiate terms.
In the short term, you’ll pay a higher interest rate to the hard-money lender. But the longer you have a loan, even with an institution that has low rates, the higher you’ll pay in interest.
Interest Rates on CRE
The interest rate on commercial real estate depends based on the type of loan that you choose. Loans backed by the SMA will usually have the lowest interest rates.
For example, a 504 loan from the SMA may have interest rates as low as 3%, according to an update from Fit Small Business.
A loan from a conventional bank will be a bit higher, from 5% up to 7%. And hard money loans from private investors will have the highest interest rates on the market. You may be paying up to 18% with interest.
What Do Lenders Look For?
We’ve talked a bit about working with lenders and some of the basic terms involved with commercial real estate financing. Before we explain how to finance commercial real estate, we’ll dive into what lenders are looking for.
Lenders typically have three sets of requirements before giving you a commercial real estate loan.
Typically, commercial real estate loans require a large capital investment. This will therefore require a high amount of scrutiny, especially because 70% of small businesses fail within the first decade.
Your lender will likely want to look over your books to ensure that you have the cash flow to repay the loan. The lender will look at your DSCR (from above, remember this is your debt-to-service ratio). Many lenders will want to see a ratio of at least 1.25.
Lenders will also take a look at your business’s credit score. How much debt do you have? Are you making payments on time?
To obtain a business loan on a commercial real estate investment, you’ll need to structure the business as a legitimate business entity, like an LLC or S-corporation. A real estate loan on a sole proprietorship would put all of your personal wealth at risk should you default on the loan.
The lender may also want to look at your personal finances. If you are investing in commercial real estate as a small company, it’s likely that you’re operating as a solo owner or just a few partners.
Lenders will want to see your personal credit score and history to see if you’ve had finical problems in the past, like defaults, foreclosures, or court judgments. A low personal credit score may make it difficult to acquire commercial loan approval.
Lastly, the lenders will look at the property itself. The property being financed by the loan acts as collateral, so they will want to evaluate the property value. To qualify for a commercial real estate loan, your business must occupy at least 51% of the building if the building already exists.
How to Finance Commercial Real Estate
Deciding that you want to obtain a commercial property will then require preparation before you go secure your loan. You’ll have to prepare your financing application and explore your different lending options.
How to Prepare for Financing Application
Applying for a commercial mortgage will require significant paperwork and can be a time-consuming process if you’re not prepared. However, you may receive a hard money loan in days.
In general, banks and lenders will ask for this information:
- Business tax returns
- Books, records, financial ports
- Your last three months of bank statements
- Details about collateral
- A third-party appraisal of the property
- A business plan
A hard-money lender may instead concentrate on the current and projected value of the property that you want, with fewer requirements for other financial documents.
To improve the chances of getting approved, improve your credit. This is especially true if you are venturing into buying a commercial property for the first time.
You can boost your chances of raising your credit score by:
- Paying off existing debt
- Choosing a less expensive property
- Offering more collateral
- Adding an investor or cosigner
- Paying a higher down payment
Being in the best financial state possible will significantly improve your chances of getting approved for a reasonable loan.
Where to Get a CRE Loan
Commercial real estate loans are available from multiple sources. Each one will have certain benefits that work best for you.
Banks usually provide commercial financing for different kinds of properties. Traditional banks will give a typical loan size of $1 million.
Banks usually provide good rates and long-term financing options. However, the process is slow and requires extensive documentation. You will only receive a bank loan if you have excellent or good credit.
Commercial lenders are non-bank finance companies that offer real estate loans for small- to medium-sized companies.
Commercial lenders will usually have faster approval, lower fees, and lower closing costs than banks. However, the convenience of working with a commercial lender will result in interest rates that are often higher than banks. Many loans will be short-term and will require a balloon payment in 5 to 10 years.
SBA 504 Loans
SBA 504 Loans were designed by the Small Business Association (SBA). They can be used for real estate or long-term equipment purchases.
These loans usually are a combination of two types of loans: about 50% of the loan comes from a bank, and 40% comes from a Certified Development Company. You are responsible for at least 10% down.
SBA 504 loans have numerous benefits: they come with below-market interest rates and terms of 20 or 25 years. The down payment of 10% is also relatively low.
However, businesses applying for this loan must meet SBA size standards, so individual lenders would have to create and operate an approved business model first. It’s also a slow funding process.
Hard-money loans are short-term loans that are based on the value of the property you’re buying. Loans are usually made by private companies and will have high down payment requirements.
Hard money lenders are great if you don’t want to have your credit rating evaluated. They’re easier to qualify for and have fast approval.
However, you’ll face much higher interest rates and only will have the option for short-term financing.
Conduit loans are a way to finance your property by pooling your mortgage with other commercial loans. Conduit loans group commercial mortgages with other commercial loans, then sell them to investors on a secondary market.
Conduit lenders will finance loans starting at the $1 to $3 million range, with terms that go up to 10 years.
Conduit lenders are great for low-interest rates and offer an amortization period that extends beyond the loan term. However, you’ll have to pay a balloon payment after the loan ends and you’ll also face prepayment penalties.
Financing CRE with No Money Down
If you want to invest in commercial real estate as soon as possible but you don’t have the capital, you still have options for financing the purchase.
You can get a loan with no money down by obtaining a purchase-money mortgage, securing an investing partner, or working with a hard money lender.
Investing partners will provide the commercial investor with the funds necessary to qualify for a loan. Having an investor will also reassure banks that there is secure financial backing for the property. However, investors will only invest if they see attractive returns
Going through a hard money lender is another option if you are short on capital. Bridge loans can help to secure short-term funding for a downpayment to later be used to negotiate a long-term loan through a traditional lender.
Investors can also consider purchase-money mortgages to finance commercial property. Purchase-money portages are also known as seller-financed details, meaning that the seller will offer a loan to the borrower to purchase the property.
Both sellers and borrowers can benefit from the flexible repayment terms and rates agreed upon. However, if the borrower fails to make mortgage payments, the seller can repossess the property.
Leveraging Commercial Real Estate Financing
If you’re looking to invest in commercial real estate, you don’t need to have all of the capital on hand. You can leverage commercial real estate financing to acquire your desired property with the desired loan.
Now that you know more about how to prepare for CRE financing and what loans exist, you can begin the process of looking for your next property.
And you don’t have to begin the process alone – the Tax Savers Online blog has numerous resources to help you with your property investments. Visit our business blog to learn more.