With interest rates rising over the past two years, it’s no surprise that commercial real estate borrowers are feeling a bit of sticker shock these days.
Banks and other lenders have also curtailed lending activity and tightened standards. In the second quarter of 2023, CRE loan originations from banks decreased by 69% from one year ago, while the dollar volume for investor-driven lenders fell 60%.
If you’re planning a commercial real estate purchase, knowledge is power when it comes to obtaining a loan and getting the best rate possible. That’s especially true in today’s challenging business environment.
In this article, Commercial One Brokers walks you through the basics of CRE lending. We’ll go over different types of loans, what lenders are looking for and how to apply for CRE financing.
Jump to:
- CRE Lending Basics
- CRE Loans vs. Residential Loans
- Types of CRE Loans
- CRE Lending Standards
- CRE Interest Rates & Other Costs
- Applying for a CRE Loan
CRE Lending Basics
Just like a residential mortgage, a commercial real estate loan is a secured loan. This means the property itself serves as collateral held by the lender until the loan is repaid. And as with a home loan, defaulting on a commercial property loan could result in foreclosure.
The biggest difference is that CRE loans are exclusively issued for properties intended to produce income for the owner, rather than for residential purposes. A CRE loan can be used to finance the following types of purchases:
- Existing commercial building space
- Land for a new facility
- Financing to build a new facility
- Renovations to existing commercial space
- Equipment or machinery for business operations
Banks and independent lending firms are the primary originators of CRE loans. Other sources of financing may include insurance companies, pension funds, private investment firms and the Small Business Administration.
CRE Loans vs. Residential Loans
Put simply, while residential mortgages are issued to individual borrowers, commercial real estate loans are exclusively for business entities. These may include corporations, developers, limited partnerships and other types of business organizations.
Here are a few other key features that distinguish CRE loans from their residential counterparts.
Loan Term
The most common type of residential loan is the 30-year fixed rate mortgage that most people are familiar with. One popular alternative is a 15-year fixed rate mortgage in exchange for a lower interest rate. The loan is amortized as the borrower repays the debt in regular monthly installments over a fixed period of time.
A commercial mortgage may be for as little as 3 years or as long as 25 years. Another key difference is that the amortization period is often longer than the term of the loan.
Loan-to-Value Ratio
Loan-to-value ratio (LTV) measures the amount of a loan as a percentage of the value of the property. For example, suppose you acquire a $900,000 loan on a property valued at $1 million. You would calculate the LTV as follows:
($900,000÷ $1,000,000) * 100 = 90%
A lower LTV typically qualifies for more generous financing. Why? When the LTV is low, it means the borrower has a higher financial stake in the property, which lowers the risk to the lender.
A typical residential loan can have a LTV of about 95%, with some USDA and VA loans reaching as high as 100%. Commercial loans are usually much lower, with common LTV ratios ranging from 65% to as high as 80%.
Loan Repayment Schedule
As noted earlier, commercial loans may range from 3 to 25 years. Additionally, the amortization period is often longer than the repayment term. Here’s an illustration:
- Suppose a borrower obtains a CRE loan with a term of 10 years but an amortization period of 30 years.
- The monthly payment is calculated based on what it would take to repay the loan in 30 years.
- After 10 years of monthly payments, the borrower makes a final balloon payment that covers the remaining balance.
- The longer the repayment schedule, the higher the interest rate the borrower will pay.
Types of CRE Loans
The most common type of commercial real estate loan is a traditional CRE loan. Other options include SBA loans, bridge loans, hard money loans, conduit lending and peer-to-peer lending.
Traditional Commercial Loans
This is the most straightforward option and is ideal for businesses with healthy credit. Most banks and other lending institutions offer secured commercial mortgage rates to creditworthy borrowers. Traditional loans typically come with a long repayment term.
Small Business Administration
For small businesses looking for lower rates, SBA loans are partially guaranteed by the U.S. Small Business Administration and issued by partner lenders. One caveat is that complex requirements may lead to funds being disbursed more slowly than with traditional loans.
Bridge Loans & Hard Money Loans
A bridge loan may be an attractive option for short-term real estate investors and those looking to out-bid all-cash buyers. The borrower gets access to a lump sum of cash but with a shorter repayment term than other loans. Borrowers should be prepared to refinance if the loan isn’t paid off quickly.
A hard money loan is similar to a bridge loan, except it is offered by private lenders rather than banks or credit unions. It also carries shorter repayment terms at higher interest rates. It may be helpful for buyers who need short-term financing and those who don’t qualify for bridge loans by traditional lenders.
Conduit & Peer-to-Peer Lending
Conduit lenders are brokers who sell loans on behalf of other lenders in return for a commission. CRE loans are often bundled with other loans and sold to investors. They are typically used by businesses seeking greater leverage, lower interest rates and protection for personal assets.
Peer-to-peer lending is when individuals fund loans rather than banks or other commercial lending organizations. They are commonly used by investors who are looking to take on greater risk and borrowers with less-than-perfect credit.
CRE Interest Rates & Other Costs
As with other types of financing, there are multiple factors that determine the interest rate on a commercial real estate loan. These include borrower creditworthiness, standards of individual lenders and the terms of individual loans.
Borrowers must also be prepared to cover a number of fees in addition to loan payments. Some costs must be paid up front before the loan is approved, while others are applied on an annual basis. Common fees include:
- Appraisal costs
- Legal fees
- Loan application fee
- Loan origination fee
- Survey fees
- Environmental reports
Most CRE loans come with prepayment restrictions to protect the lender’s anticipated yield on the loan. If the loan is paid off before maturity, the borrower may be hit with one of the following penalties:
- Prepayment penalty: The outstanding balance is multiplied by a fixed prepayment percentage.
- Interest guarantee: The lender receives a minimum amount of interest even if the loan is paid in full early.
- Lockout: The loan may include a minimum term during which the borrower cannot repay the loan in full. The lockout term may be 5, 10 or other predetermined number of years.
- Defeasance: The borrower may pay a penalty for exchanging new collateral, such as U.S. Treasuries, in place of the original loan collateral.
Applying for a CRE Loan
Prospective borrowers are adopting a variety of strategies amidst the current high interest rate environment. Many are seeking shorter loan terms, while others are seeking greater prepayment flexibility in hopes of refinancing if rates fall in the future. Those with existing commercial lending terms are seeking more extensions or modifications in hopes of preserving the low payments they may already enjoy.
Whatever approach you choose, the basics of applying for a commercial real estate loan remain. Here are the steps involved in obtaining CRE financing.
Personal Finances
First, commercial lenders will take a look at a borrower’s individual finances. Here are a few criteria of interest.
- Credit score: The higher your score, the lower your interest rate. A minimum of 680 is preferred for SBA loans. Paying off outstanding debts and reducing loan balances are good tips for increasing your score.
- Debt-to-income and net worth: Both of these metrics indicate a borrower’s financial stability and responsibility. Lenders will examine what percentage of your income goes to paying debts. Your net worth is a measure of financial assets minus outstanding debts.
- Liquefiable assets: Borrowers should be prepared to share bank statements and other documents as proof of ability to repay debts.
- Financial history: Lenders will take a look at tax returns, as well as any recent foreclosures, bankruptcies or loan defaults on your record.
Business Finances
As with individual borrowers, lenders will consider the financial health of business entities involved in a CRE purchase.
- Business credit score: This typically falls between 0 and 100. Lenders generally prefer 75 or higher. A robust personal credit score may sometimes offset a lower business credit score.
- Business assets: This is any assets that could be liquidated to cover a loan. Examples include cash on hand, pending invoices and equipment.
- Net operating income (NOI): This is the entity’s profitability after expenses are paid. Many lenders require a minimum NOI to qualify for financing.
- Time in business: In general, the longer you’ve been in business the better. Some lenders require a minimum number of years. Be prepared to share tax returns as a reference.
- Business licenses: Be prepared to share any licenses or certifications required for your industry or jurisdiction.
Property of Interest
The lender will need to see the following information on the property of interest:
- Physical address
- Type of property, such as office, retail, mixed use or multi-family
- Owner occupancy rate, which means the % of leasible space to be occupied by a particular business
- Sale price of the property
- Amount needed for post-purchase renovations
- Revenue-generating tenants already present
- Expected earnings from revenue-generating tenants
Application Process
As with other types of loans, prospective borrowers should come prepared when applying for CRE financing. Here are a few essential steps for getting a loan at the most attractive rate possible:
- Have all required information collected and ready to submit.
- Apply for multiple lenders to find the best deal.
- Apply to all within a 30-day window to avoid a negative hit on your credit report.
The lender will review your application and have the property appraised before reaching a decision. The CRE application process may last from a few days to a few months, depending on the property and amount of information involved.
Trusted CRE Experts
Commercial One Brokers has over 60 years of combined experience in Branson commercial real estate. Our in-depth industry knowledge and connections within the Branson community enable us to provide the unmatched service our clients expect.
If you’re looking to purchase commercial real estate in the Branson area, give us a call at 417-334-3149 or contact us online today for more information.
