You’ve found yourself a property to set your business up in. Congratulations! Your next step is to pay for one, and more likely than not, you’ll be doing so with a commercial real estate loan. Knowing the ins and outs of these loans will make the process of getting one go a lot smoother and help you get the most out of your loan.
What is it?
A commercial real estate loan is a loan meant to help businesses finance property purchases or developments. Unlike other loans that get lent out in your name, a commercial real estate loan will be lent under your business’s name, not your own.
How does it work?
Commercial real estate loans work similarly to mortgage loans and are secured by liens on the property. Liens are “a legal right that an owner of a property gives to a creditor” and acts as a fail-safe for the lender should you default on your loan. If that were to happen, the lien grants the lender the possibility to seize any claimed asset. When taking out a commercial real estate loan, expect to, at minimum, have a lien put down on your business’ property; also expect the likelihood of putting down a downpayment onto your loan as well. This can be about 20-30% of the property price you’re purchasing.
Commercial real estate loan amounts typically range from $200,000 to over $20 million and are based around two different ratios: After-Repair Value (ARV) and Loan-to-Value (LTV). ARV compares “your loan amount to the post-renovation value of your property” while LTV compares your loan amount to the current value of your property. Keep in mind that when you’re looking for loans, these two ratios will have a significant impact against the amount you end up taking out: banks will loan out about 80% LTV of your property value, and hard money lenders will range between lending 50-70% ARV of your property value.
Unlike residential loans, which you can pay off in regular, fixed installments over a long period of time, commercial loans have a much shorter payback period. This leads to two types of terms: intermediate-term, which is paid in three years or less, and long-term, lasting from five to 20 years.
Commercial loans also have two different types: amortized and balloon. Amortized loans are more commonly known because, as with most other loans, they are paid off in fixed payments until both the loan and interest are paid back to the lender in full. Balloon commercial real estate loans, on the other hand, are far more stringent. Typically, these loans last about five to seven years, and like the amortized loans, fixed payments are set up throughout that time. However, unlike amortized loans, these payments aren’t meant to fully pay off the loan amount. Instead, you’ll have paid off only a portion of the principal balance, and at the end of the repayment term, the rest of the balance is due all at once. If you don’t have the balance by the time your term is up, you’ll either have to refinance your loan or sell your business property, so only sign for a balloon loan if you’re certain you’ll have the amount when your repayment term is up.
Interest and Fees
The interest rate on your commercial real estate loan depends on three things: the type of business you’re running, its financial health, and its credit history. These interest rates tend to come much steeper than a mortgage’s might, mainly because businesses are riskier to lend out to—this especially applies to businesses that are just starting out. The interest rate is also dependent on the lender you go to, as banks will have a different interest rate than, say, a car insurer. The interest rate for a commercial real estate loan can be anywhere from 5% to 30%.
The LTV of your property is also a big factor in your interest rate. If you’ve got a high LTV, the lender is taking a bigger risk and faces a much higher loss if you were to default on your loan, therefore making your interest rate steep. On the other hand, if you’ve paid a decent amount in your downpayment and have a lower LTV, you will likely receive a lower interest rate because the lender has less to lose.
Also be aware of any fees that may come your way thanks to the loan. Most commercial real estate loans have upfront fees that you’ll need to pay—generally bundled up into one large fee, but fees may also come with paying off your loan early. There could be a penalty for that alone, but you may also be fined for interest guarantee, defeasance, or not be allowed to pay it off early at all. Have any and all fees explained to you before taking out a loan so none of them take you by surprise.
Applications for commercial real estate loans are more heavily scrutinized than residential loans are. Lenders want to know everything about your business plan and your plans for using the property you’d like to purchase. Have as many details clearly spelled out as possible so you have an answer for any questions, leaving nothing to chance. For larger loans, be prepared to also provide your business’ financial documents (assets, tax returns, etc.) along with your personal financial information and credit history.
Getting loans can be stressful, especially when your business depends on getting a certain property. However, knowing what to expect will make things easier for you in the long run and, hopefully, help you make the best financial decision for your business. Once you’ve signed the line, you’re committed, so be confident in the loan you take out and focus on helping your business grow and succeed.