Commercial Real Estate Loans: Overview, Types & Terms

Residential real estate is an asset class with which many people have familiarity, and the financing that facilitates its purchase is so common that fluctuations in rates and other shifting market conditions make the evening news. Commercial real estate loans are another matter. Many unfamiliar with this kind of financing assume that it must function in a similar way to home loans since both secure real estate. However, that's not true. Commercial real estate loans' rates, amortization schedules, terms, penalties, and credit requirements all differ significantly from those used to purchase single-family residences. 

In this article, we will define what commercial real estate loans are, their various types, what kind of loan you should get, and how you should go about getting it.

What Is a Commercial Real Estate Loan?

The reason why many people may not initially grasp that there are several types of commercial real estate loans is that they believe the answer to its nature is right in its name. It's a loan. It's for real estate. And its real estate used for commercial purposes. All of that is true — but if fails to capture why commercial real estate lending guidelines are what they are. 

The most defining element of commercial real estate is that it's used to produce income, either through regular quantifiable streams or a future lump sum. People may live in a commercial property, but they won't be the people seeking financing for it. Instead, they will be entities (e.g., partnerships, corporations, LLCs) seeking to turn a profit. That single factor informs every part of the lending process and radically changes how this sort of financing works. 

Following you will find several ways in which commercial real estate loans are distinct from other kinds of financing. 

Types of commercial real estate loans 

Categorizing commercial investment property loans can prove challenging because they can be delineated in a number of different ways. One lens through which to view them is the purpose of the loan. Most assume that these loans exist solely to purchase property, but that's not accurate. They can also be used to refinance existing debt or renovate or alter the property in some way. 

Another category focuses on the terms of the loan, which may conform to a number of different standards. For example, permanent loans or first liens comprise the majority of commercial real estate loans, and these function somewhat similarly to residential mortgages (although we will highlight a number of crucial differences in the next paragraph). Sometimes, though, projects may require a short-term bridge loan to tide them over as they look for additional financing. Finally, the very confident or especially desperate may seek out a hard-money loan, which covers only a very small portion of the property's value and typically has a nearly usurious interest rate. When commercial borrowers resort to hard-money loans, their goal is either to swiftly sell the property or refinance it as quickly as possible. 

Finally, one can sort commercial real estate financing according to the underwriting requirements of the loan (i.e., the commercial property loan requirements). These requirements can vary substantially from lender to lender, and they're also where the differences between residential and commercial real estate lending becomes more pronounced. While listing every underwriting requirement goes beyond the scope of this article, these general standards will provide several broad guidelines: 

• Net Operating Income (NOI): Defined as gross income minus all vacancy, credit loss, and operating expenses, this sum is essential to determining how much of a loan the property can support. 
• Loan To Value Ratio (LTV): A measure of how much of the property is mortgaged, this ratio determines the upper value of a commercial real estate loan. Commercial property financing rarely goes above an 80 percent LTV and can be as low as 65 percent. Commercial real estate loans with no down payment do not really exist. 
• Debt Service Coverage Ratio (DSCR): DSCR is calculated by dividing the NOI by the annual cost of servicing the loan. Properties the lender deems more risky than others will receive a higher DSCR, which provides more margin for the financial institution if the real estate fails to realize its income. 
• Capitalization Rate (Cap Rate): A percentage that indicates the expected return of a property according to its asset class and local market conditions. By discounting all anticipated future cash flows using a cap rate to a single present value, lenders can determine what a piece of commercial real estate is worth and how much they will lend against that value. 
• Amortization Period / Repayment Schedule: Amortization (i.e., repayment of varying amounts of interest and principal) periods for commercial real estate loans are often longer than the note's term, leaving a lump sum that must be paid at the end. This sum is known as a balloon. 
• Penalties and Fees: Lenders may include prepayment penalties and other fees to ensure that they realize a certain level of profitability. 

Individuals vs. Entities

One of the defining elements of commercial real estate lending is that it typically isn't made to individuals. Usually entities of some sort, such as corporations, partnerships, trusts, or development businesses, are the ones signing off on the loan. However, that doesn't mean that an individual can necessarily avoid personal responsibility for the debt. Entities often lack any credit history of their own, and in some instances, lenders or banks may require individuals to personally guarantee the repayment of the debt. 

Commercial Real Estate Loan Interest Rates and Fees

Rates for commercial real estate can vary wildly depending on market conditions, loan types, terms, deal structures, and personal creditworthiness. Loan aggregator Fundera has compiled a list of average rates and fees, showing that overall rates can range from as low as 2.5 percent to as high as 20 percent. Noteworthy examples include: 

• Traditional Permanent Loans: 5 to 7 percent 
• Bridge Loans: 3 to 20 percent 
• Hard Money Loans: up to 20 percent 
• Warehouse Loans: 2.5 to 12 percent 
• Land Loans: approximately 5 percent 

Note that lenders may include various fees such as appraisals, origination fees, survey fees, legal fees, and the like. Some may require separate payments upfront, while others may fold them into the loan, listing them as points. (A point is a single percent of a loan and can be delineated in fractional amounts.) 

Residential Loans vs. Commercial Real Estate Loans: Key Differences  

Residential loans differ significantly from those used to finance commercial real estate. Common characteristics of residential lending include the following: 

• Intended for property that the borrowers will occupy 
• Underwriting focuses on the borrower's credit score 
• Made to individuals 
• High loan to value ratios (up to 100 percent) 
• Amortization periods that match the loan's length 

Commercial loans have significant differences: 

• Intended for non-owner-occupied property that produces an income stream 
• Underwriting focuses on income- and value-related factors, often only considering credit scores for personal guarantees 
• Made to entities 
• Lower loan to value ratios (65 to 80 percent) 
• Often require balloon payments at the end of the loan's term 

How to choose the best loan for my needs/requirements  

Choosing the ideal loan for your purchase, remodel, or refinance will largely depend on your specific property and financial situation. The ideal loan will be one with a term in which you believe you can pay it and with the lowest possible rate. You must also qualify for said loan, which will require you to provide info about your business' finance (e.g., income, debt, credit history) and the property's specific characteristics. Depending on your situation, you may need to offer your personal credit history as well. 

Should you use a commercial real estate loan?  

For most borrowers, a traditional permanent loan will provide the most flexibility at the best price. However, some situations can lead you to consider other financial product. If you meet their somewhat stringent eligibility requirements, a U.S. Small Business Administration (SBA) loan might be an option. Short-term purchasers or those with challenged credit might look at hard money loans as well. 

How and where to get a commercial real estate loan  

Commercial real estate financing is available from banks, credit unions, the SBA, and conduit lenders. Additionally, peer-to-peer lenders can provide commercial loans through online portals. If you're wondering where and how to get such a loan, contact us here at Millennium Properties. We have extensive experience with all sorts of commercial property and a large network of lenders.