Since commercial real estate is specific to an income-producing property that is used only for business purposes, i.e. mall, shopping center, office building, warehouse, and hotel, financing is done through a commercial loan. A lot of times that can mean the mortgages are secured by liens on the commercial property. Just as you see with a home mortgage, banks and independent lenders are involved in commercial loans. In this article, we are going to take a closer look at commercial real estate loans, how they differ from residential loans, what their characteristics are and what lenders are looking for.
Just as residential mortgages are individual borrowers, commercial real estate loans are often made to business entities, such as corporations, developers, limited partnerships and trusts. In many cases, one might form these entities for the sole reason of owning some commercial real estate. Because of this, an entity might not have a financial track record or credit rating, which typically leads to the lender requiring the principals of the entity to guarantee the loans. This will then provide the lender with the credit history of the parties involved and gives them a place to recover in the event of loan default. In some cases, you might have a non-recourse loan instead, which means that the lender doesn’t have a path to recourse against anyone or anything other than the property itself.
Unlike residential loans where you have an amortization schedule, the terms of commercial loans typically range from five years (or less) to 20 years, and the amortization period is often longer than the term of the loan. A good example is that a lender could provide a commercial loan for a seven-year term with an amortization period of 30 years. What that means, is that the payments made for the first seven years would be for an amount based on the loan being paid off in 30 years. Then they would make one final “balloon” payments of the entire remaining balance of the loan.
Based on the credit strength of the investor, the loan term and the amortization period could be negotiated, which is great as this affects the rate of the loan. Generally speaking, the longer the repayment schedule is for the loan the higher the interest rate.
Another major part of commercial real estate loans is the loan-to-value ratio. This is a figure that measures the value of the loan against that of the property. A lender will look at this ratio by dividing the amount of the loan by either lesser of the property’s appraised value or sale price. The lower the loan-to-value ratio, the better financing rates should be. Why? Because they have more equity in the property, which means less risk to a lender. The loan category my also factor into how high a lender will go based on LTV.
One big thing to know is that in commercial lending there is no FHA or VA programs and no private mortgage insurance. This is a big reason lenders rely on real property as security since they cannot have insurance.
Another piece of the puzzle that commercial lenders look at is the debt-service coverage ration. This will compare the property’s annual net operating income to the annual mortgage debt (including interest and principal). Which also one to measure the ability of the property to service debt. The ratio can help a lender determine the maximum loan size based on the cash flow the property generates.
It is always important to speak with your broker about how all these ratios are taken into account. Everything is based on what the lender is thinking, and then additional factors like shorter amortization periods or properties with stable cash flow. Based on these other factors, these ratios may have more or less of an impact.
Commercial real estate loans typically have a higher rate than you will see with a residential loan. Also, they have many additional fees associated with them, including the appraisal fee, legal fee, loan-application fee, loan origination fee, and/or survey fees. It is possible to pay some of these costs upfront, while others are paid annually. It is important to communicate with your broker so that you know what fees are due when.
When you are looking at a commercial real estate loan, you may have some restrictions as far as prepayment is concerned. This is because these loans are designed to give the lender a certain yield on a loan. If you can settle a debt before the maturity date of the loan, there may be some penalties associated with prepayment. Below are some common options that we see – again it is important to discuss all this with your lender and broker to make sure that you fully understand the loan you are getting.
Prepayment Penalty. The most basic prepayment penalty we see. It is calculated by multiplying the current outstanding balance by a specified prepayment penalty.
Interest Guarantee. The lender is entitled to a specified amount of interest, even if the loan is paid off early. You may be responsible for the remaining interest.
Lockout. A specified amount of time that the borrower cannot pay off the loan before.
Defeasance. A substitution of collateral. Instead of paying cash to the lender, the borrower exchanges new collateral (usually U.S. Treasury securities) for the original loan collateral.
Prepayment terms are identified in the loan documents and can be negotiated along with other loan terms in commercial real estate loans.
Loans with commercial real estate are different than most are used to. As they should be since this is geared towards an income-producing property rather than somewhere you will be living. When evaluating commercial real estate, always keep an open line of communication with your broker. It is important to have support and guidance through this stage so you always know what to expect.
And remember, that lenders consider the collateral of the loan, the credit of the entity, financial statements, tax returns, and financial ratios when making a decision.
Common Questions About Commercial Real Estate Loans Denver:
Space Selectors is able to provide the knowledge and expertise needed to help connect you to the right people when looking into a commercial real estate loan. Book a consultation today so you can speak with an expert and get started in the right direction with all your commercial real estate needs!