With interest rates rising over the past two years, it’s no wonder commercial real estate borrowers have been feeling a bit of a consternation lately.
Banks and other lenders are also scaling back lending activity and tightening standards: In the second quarter of 2023, bank CRE loan origination volume fell 69% year over year, while investor-led lender origination volume fell 60%.
If you’re planning on purchasing commercial real estate, knowledge is power when it comes to obtaining a loan and getting the best possible interest rate. This is especially true in today’s tough business environment.
In this article, Commercial One Brokers covers the basics of CRE financing: the different types of loans, what lenders are looking for, and how to apply for CRE financing.
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CRE Lending Basics CRE Loans and Home Loans Types of CRE Loans CRE Lending Standards CRE Interest Rates and Other Fees Applying for a CRE Loan
CRE Financing Basics
Like a mortgage, a commercial real estate loan is a secured loan, which means that the property itself is held by the lender as collateral until the loan is repaid. And, like a mortgage, defaulting on a commercial real estate loan can lead to foreclosure.
The biggest difference is that CRE loans are only issued for properties that are intended to generate income for the owner, not for residential use. CRE loans can be used to finance the following types of purchases:
Existing commercial building space, land for a new facility, financing for the construction of a new facility, renovation of existing commercial space, equipment or machinery for business operations
The primary providers of CRE loans are banks and independent lenders. Other sources of funding include insurance companies, pension funds, private investment firms, and the Small Business Administration.
CRE Loans and Mortgages
Simply put, residential mortgages are issued to individual borrowers, while commercial real estate loans are only for business entities. This can include corporations, developers, limited liability partnerships, and other types of business organizations.
Here are some other key characteristics that distinguish CRE loans from mortgages.
Loan Term
The most common mortgage is the 30-year fixed-rate mortgage that most people are familiar with. One popular alternative is the 15-year fixed-rate mortgage in exchange for a lower interest rate. The loan is repaid by the borrower repaying the debt in regular monthly installments over a set period of time, resulting in amortization of the principal.
Commercial mortgage terms can range from as short as three years to as long as 25 years. Another important difference is that the amortization period is often longer than the term of the loan.
Loan-to-Value Ratio
Loan-to-value (LTV) ratio measures the amount of the loan as a percentage of the value of the property. For example, say you take out a loan of $900,000 on a property worth $1 million. Calculate your LTV as follows:
($900,000 ÷ $1,000,000) * 100 = 90%
The lower the LTV, the more generous the loan you can usually get. Why? A lower LTV means that the borrower has a higher financial stake in the property, making it less risky for the lender.
A typical mortgage has an LTV ratio of around 95%, although some USDA and VA loans can go as high as 100%. Commercial loans are usually much lower, with typical LTV ratios ranging from 65% to 80%.
Loan repayment schedule
As mentioned above, commercial loan terms range from 3 to 25 years. Also, the amortization period is often longer than the repayment period. For example:
Let's say a borrower gets a CRE loan with a 10-year term and a 30-year amortization period. The monthly payments are calculated based on how much it would take to pay off the loan over 30 years. After 10 years of monthly payments, the borrower makes a final balloon payment to cover the remaining balance. The longer the repayment schedule, the higher the interest rate the borrower pays.
Types of CRE Loans
The most common 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 easiest option and works best for businesses with good credit. Most banks and other lending institutions offer secured commercial mortgage rates to creditworthy borrowers. Conventional loans usually have a long repayment term.
Small and Medium Enterprise Agency
For small businesses looking for lower interest rates, SBA loans are partially guaranteed by the U.S. Small Business Administration and issued by partner financial institutions, with the caveat that funds may be disbursed more slowly than traditional loans due to complex requirements.
Bridge Loans and Hard Money Loans
Bridge loans may be an attractive option for short-term real estate investors or those looking to outbid all-cash buyers. Borrowers get access to a lump sum of cash, but the repayment period is shorter than other loans. Borrowers should be prepared to refinance if the loan is not paid off quickly.
Hard money loans are similar to bridge loans, except they're provided by private lenders rather than banks or credit unions, and they have shorter repayment terms and higher interest rates. They can be helpful for buyers who need short-term financing or who don't qualify for a bridge loan from a traditional lender.
Conduits and Peer-to-Peer Lending
A conduit lender is a broker that sells loans on behalf of other lenders in exchange for a fee. CRE loans are often bundled with other loans and sold to investors. CRE loans are typically used by businesses looking for greater leverage, lower interest rates, and protection for their personal assets.
Peer-to-peer lending is when individuals raise loan funds rather than through banks or other commercial lending institutions. It is often used by investors who want to take on greater risk, or by borrowers with less than perfect credit.
CRE Interest Rates and Other Costs
As with other types of loans, there are multiple factors that determine the interest rate on a commercial real estate loan. These include the borrower's creditworthiness, the individual lender's criteria, and the terms of the individual loan.
Borrowers must also be prepared to pay a number of fees in addition to the loan payment. Some fees must be paid up front before the loan is approved, while others are applied annually. Common fees include:
Appraisal fees Lawyer's fees Loan application fees Loan fees Investigation fees Environmental reports
Most CRE loans have prepayment restrictions in place to protect the lender's expected yield. If the loan is repaid before maturity, the borrower may be subject to one of the following penalties:
Prepayment Penalty: The outstanding balance is multiplied by a fixed prepayment rate. Interest Guarantee: The lender receives a minimum amount of interest even if the loan is repaid in full early. Lockout: Loans may include a minimum period during which the borrower fails to repay the loan in full. The lockout period may be five, ten, or some other predetermined number of years. Defeasance: The borrower may pay a penalty to exchange new collateral, such as U.S. Treasury securities, in place of the original loan collateral.
Applying for a CRE Loan
Prospective borrowers are employing a variety of strategies in the current high interest rate environment. Many are seeking shorter loan terms, while others are seeking more flexible prepayments so they can refinance if interest rates fall in the future. Those with existing commercial loan terms are seeking further extensions or modifications in hopes of maintaining the low payments they already enjoy.
No matter what approach you choose, the fundamentals of applying for a commercial real estate loan remain the same. Here are the steps you need to take to get CRE financing:
Personal Finance
First, commercial lenders will look at your personal finances. The criteria they use to qualify include:
Credit score: The higher the score, the lower the interest rate. For SBA loans, a minimum of 680 is desirable. Paying off outstanding debts and reducing loan balances are good tips to increase your score. Debt-to-income ratio and net worth: Both of these metrics indicate a borrower's financial stability and responsibility. Lenders look at what percentage of your income goes towards paying off debts. Net worth is financial assets minus outstanding debts. Liquidizable assets: Borrowers should be prepared to provide bank statements and other documents as proof of their ability to repay debts. Financial history: Lenders will review tax returns and records of recent foreclosures, bankruptcies, and loan defaults.
Business Finance
As with individual borrowers, lenders consider the financial strength of the entities involved in a CRE purchase.
Business credit score: This is usually between 0 and 100. Lenders usually prefer 75 or above. A solid personal credit score may make up for a low business credit score. Business assets: These are assets that can be converted into cash to repay the loan. Examples include cash on hand, outstanding invoices, and equipment. Net operating income (NOI): This is the profitability of an entity after expenses are paid. Many lenders require a minimum NOI to qualify for a loan. Length of business: Generally, the longer you've been in business, the better. Some lenders require a minimum number of years. Be prepared to provide tax returns for reference. Business licenses: Be prepared to provide any licenses or certifications required in your industry or jurisdiction.
Properties of Interest
Lenders will need to verify the following information about the property you are interested in:
The physical address The type of property, such as office, retail, mixed-use, or multifamily The owner occupancy rate (the percentage of rentable space that is occupied by a particular business) The selling price of the property The amount needed for post-purchase renovations The revenue-producing tenants already in the property The expected revenue from those revenue-producing tenants
Application Process
As with any other type of loan, potential borrowers need to be well prepared when applying for a CRE loan. Here are some important steps to ensure you get the loan at the most competitive rate possible.
Gather all the required information and be ready to submit it. Apply to several lenders to find the best terms. Apply to all within 30 days to avoid negatively impacting your credit report.
Lending institutions will review your application and appraise the property before making a decision. The CRE application process can take anywhere from a few days to a few months, depending on the property and the amount of information involved.
CRE Experts You Can Trust
Commercial One Brokers boasts over 60 years of combined experience in Branson commercial real estate, and our in-depth industry knowledge and connections to the Branson community allow us to provide the unparalleled service you have come to expect.
If you are looking to purchase commercial real estate in the Branson area, call us at 417-334-3149 or contact us online today to learn more.