How Commercial Real Estate Loans Work
You have an idea how to make money. You make a business plan. You looked up properties online and found what you think is the right one for your small business.
However, there’s a problem – the price made you raise your eyebrows. Should you look for commercial real estate loans?
Maybe this is not the reason why you would consider taking a financial injection. Maybe you are just expanding to a new location or renovating your current space. Whatever the reason is, your small business would take a financial hit.
This is where knowing the pros and cons of commercial loans come in handy.
How do business loans work? What’s the deal with commercial real estate lenders?
Grab a note and sharpen your pen, because it is time for some tips that may save capital for your business.
We will start with defining the term. Commercial real estate – whether it is a warehouse, a property, a two-story home – is real estate that is used for business, no matter its size.
The loan that we are talking about here is an option for current or future business owners to acquire financing that they need for commercial use. As you may have guessed by now, only businesses can take out commercial real estate loans. Not individuals.
So, how does commercial real estate lending work?
It allows you to fund your new business property purchase if you or your company does not have enough financing for it.
Wait, that sounds familiar…
Researching the internet, you may have come across the term “mortgage loans”. Commercial real estate loans are in a way mortgage loans secured by liens on the property you are purchasing.
A lien is a legal right that an owner of property gives to a creditor as a way of guaranteeing for the payment of the loan. If the owner does not fully repay his debt, the credit might be able to seize the asset.
It serves as a protection against the risk.
With all of that said, you should expect to have a lien put on the property when taking a commercial real estate loan.
Commercial real estate lending companies will require a down payment which should be somewhere between 20 and 30 percent of the property purchase price.
Types of commercial property loans
A bridge loan is a short-term loan, usually with a term of one year or so, and is used to give financing to a borrower for his project’s needs. A business owner obtains a bridge loan while waiting for long-term financing to come through.
In this case, we have private lenders on the lending side, which require a remarkable credit score and proof of income, since they are exposing themselves to financial risk.
Real Estate Purchase Loans
This way of commercial real estate financing is similar to fixed-rate and adjustable-rate commercial mortgages. The borrowers are expected to have an outstanding credit score (700 and above), and significant savings on their business and personal bank accounts, to qualify.
The loan’s interest rate is determined by a loan-to-value ratio, and the commercial property is used as collateral.
Hard Money Loans
This is a variant of a bridge loan. It is also called “last resort” loan as it carries high-interest rates. In order to qualify for a hard money loan, the owner of a property must list it as the collateral even if they will use it to save the property.
As with bridge loans, hard money loans are offered by private individuals who see value in this risky lending.
Joint Venture Loans
If all parties share equally in a property’s profits and losses, a joint venture loan is the best option of acquiring money if neither party can obtain enough financing on his own. Usually, two partners in a group apply for the financing together.
This is a type of mortgage that allows the lender to share in part of income made by commercial property. The lender participates in the revenue of the mortgaged property along with interest.
What is Debt-Service Coverage Ratio (DSCR)?
This is something you may or may not know. Debt-Service Coverage measures if your cash flow available to pay your current debt obligations, and it is one of the commercial real estate loan requirements.
DSCR compares a property’s annual net operating income to its annual total debt service, including principal and interest. This ratio shows lenders what can their maximum loan size be based on the cash flow generated by the property.
If the result is less than one, it indicates negative cash flow. Lenders usually look for at least 1.25 NOI to TDS ratio, depending on the type of business.
Commercial real estate loan rates and fees
Interest rates on commercial real estate loans are higher than on residential ones, and this is not a surprise. Additionally, these loans involve fees like appraisal, legal, loan application, origination and survey fees that add up at the end of the day.
Some of the costs must be paid upfront even before the loan is approved or rejected, while others are paid annually.
One of the commercial loan terms can have some restrictions on prepayment. Quick reminder, prepayment is the settlement of a debt payment before its due date. In this case, if you are the borrower, you will have to pay prepayment penalties.
These terms are identified in the loan documents and can be negotiated.
Here is a list of four prepayment penalties:
- Prepayment Penalty, which is calculated by multiplying the current outstanding balance by a specified prepayment penalty.
- Interest Guarantee, which entitles the lender to a specified amount of interest.
- Lockout, in which the borrower cannot pay off the loan before the agreed period.
- Defeasance, in which the borrower substitutes the collateral. So, for instance, instead of paying cash, the borrower can choose to pay with something else, like U.S. Treasury securities.
Ending thoughts on a commercial real estate loans
If you are looking for a commercial loan to realize your business idea, you must have a look at multiple options from different lenders. You should always be looking to get the best terms and rates for your business.
Once you find that perfect fit, it is time to take your small business to the next level.
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