Commercial Real Estate Financing

Commercial real estate (CRE) financing can help cover funding for your business while helping keep the conditions of the loan minimal. Keep reading to learn more about the terms, conditions, and requirements of a CRE Loan.

Let’s rewind to 1994, in a small garage in Washington where the building blocks for the global giant Amazon were laid. In just a year, Amazon moved from the rental garage to a small warehouse. Bezos’ humble beginning is still an inspiration to many startups and small business entrepreneurs. 

Much like Bezos, numerous entrepreneurs today stand at the crossroads of expanding their operations and delving into real estate investment. However, the transition from a home office, garage, or small rental space to a commercial property requires significant capital. 

That’s where commercial real estate financing stands as a beacon, offering the funding to acquire, develop, or renovate business properties. This guide seeks to illuminate those paths, helping you make informed decisions for your company's future. 

What is Commercial Real Estate Financing?

Commercial real estate financing is a specialized segment of the lending industry that provides businesses with the capital to purchase, develop, or refinance commercial properties. 

The average loan amount ranges from $100,000 to over $5 million. Terms generally extend from five to 20 years, with interest rates varying based on factors like the lender, loan type, and the borrower's creditworthiness. As of 2023, commercial real estate financing rates started at 3%.

The funds from commercial real estate financing can be utilized for a myriad of purposes, from purchasing office buildings, warehouses, and retail spaces to developing raw land or renovating existing structures. 

When it comes to commercial real estate financing options, there's no one-size-fits-all approach. A variety of real estate loan types are available to business owners, such as real-estate-secured loans, traditional bank loans, and SBA loans.

How Commercial Real Estate Loan Works

Now that you know the various use cases for commercial real estate loans, it is recommended to learn how a real estate loan works.

If you qualify for a real estate loan, the lender will typically require a down payment. Businesses are often required to front between 20% to 40% of the property's purchase price. The loan will then be used to cover the remaining balance. Based on this loan amount and the business's creditworthiness, the lender will determine interest rates.

For real estate loans, there are two principal interest structures. With a fixed rate, the interest remains unchanged throughout the loan, offering a sense of predictability in monthly payments. 

On the other hand, a variable rate periodically changes based on market benchmarks. Variable interest rates can offer flexibility and interest savings if the rate lowers throughout the loan term. However, there is always the possibility that interest rates will increase.

Repayment of real estate loans often follows an amortized structure. This means the monthly payments are divided, with a portion going toward the interest and principal. 

In some cases, real estate loans will have a balloon payment structure. These repayments will feature smaller monthly payments in the beginning, with a larger final payment at the end of the loan term.

To determine your eligibility for a real estate loan, lenders often sift through the business's financial health, poring over elements like credit scores and cash flow. Another factor lenders consider is the debt-service coverage ratio (DSCR), which measures the company’s cash flow to its current debts. The DSCR is used to determine whether the company can take on additional debt.

Apart from the business's financial profile, the commercial property itself is put under the lens. An appraisal process ensures that the loan amount aligns with the property's value. In some cases, the property may be used as collateral to secure the loan.

Advantages of Commercial Real Estate

Investing in commercial real estate can be a significant step forward for many businesses. Here are some standout advantages of securing such a loan:

• Customizable Terms: A commercial property loan may come with flexible terms. These terms may be tailored to suit your business's cash flow.
• Competitive Interest Rates: Relative to other types of loans, commercial real estate loans can come with more attractive interest rates, primarily because the loan is secured by the property itself.
• Stable Expense Forecasting: With a fixed-rate commercial real estate loan, businesses can anticipate their monthly payments accurately, aiding in long-term financial planning. 
• Enhanced Cash Flow Management: Instead of spending a large sum upfront to purchase property, businesses can maintain their cash reserves by making manageable monthly payments. This allows for better liquidity and operational flexibility.
• Building Business Credit: Regularly making payments on a commercial real estate loan can significantly bolster a business's credit profile, which can be beneficial for future financing needs.
• Potential for Loan-to-Value Ratios: Some commercial real estate loans offer high loan-to-value (LTV) ratios, meaning businesses might not need to pay as large of a down payment, preserving cash for other endeavors.
• Refinancing Opportunities: As businesses grow and evolve, and as market conditions change, there's potential to refinance the original loan. This could result in better interest rates or loan terms that align more closely with the business's current situation.

Disadvantages of Commercial Real Estate

While real estate loans offer numerous advantages to businesses, entrepreneurs should approach the decision with a well-rounded perspective. Here are some potential drawbacks when financing commercial properties with a real estate loan:

• Upfront Costs: Beyond the down payment, there are other initial costs like appraisal fees, environmental assessments, and loan origination fees that can be hefty.
• Collateral Risk: The property itself often serves as collateral for the loan. If the business fails to keep up with payments, there's a risk of losing the property to the lender.
• Interest Rate Fluctuations: If you opt for a loan with a variable interest rate, there's a chance that interest rates might rise, increasing your monthly payments and the overall cost of the loan.
• Balloon Payments: Some loans have a balloon payment structure, requiring a large sum at the end of the loan term. If the business isn't prepared, this can pose significant financial strain.
• Flexibility Limitations: Refinancing or restructuring the loan before its maturity might come with penalties or restrictions.
• Property Depreciation: If the value of the property drops, you could find yourself owing more than it's worth, which can be problematic if you wish to sell or refinance.
• Complex Application Process: Unlike some other loan types, commercial real estate loans often have a more involved application process. Lenders require a lot of documentation, and the approval can be time-consuming.

Types of Commercial Real Estate Loans

Navigating the world of commercial property financing reveals a spectrum of loan options, each tailored to specific business needs and investment strategies. Whether a company is looking to purchase a ready-to-use office space or construct a new facility, there's a loan type designed to facilitate the process. 

In the following sections, we'll delve deeper into each type, shedding light on their unique attributes and potential benefits for business owners.

Traditional Bank Loans

For many business owners, the first port of call when seeking commercial real estate financing is the traditional bank loan. These are time-honored financial instruments offered by local, regional, and national banks, and they come with a degree of familiarity and trust for many entrepreneurs.

Typically, loan amounts range from a few hundred thousand dollars to multi-million-dollar deals, largely depending on the value of the real estate and the borrowing capacity of the business. Interest rates can either be fixed or variable, with terms usually spanning between five to 20 years.

Business owners often prefer traditional real estate loans because they offer the following benefits: 

• Reliability: With established banks, you know what you're getting into. Their processes are standardized, and they have a reputation.
• Relationship Building: If you already conduct business with the bank, securing a loan can help cement that relationship, possibly opening doors to other financial products or favorable terms in the future.
• Competitive Rates: Often, traditional banks offer competitive interest rates between 5% and 7%, especially if you have a strong business credit history.

Nevertheless, there are some downsides to traditional loans, causing businesses to look for alternative financing options. Here are some of the disadvantages:

• Stricter Requirements: Banks are often stringent with their lending criteria, including high credit score requirements and a proven track record of profitability.
• Longer Approval Times: Compared to some alternative lenders, banks might take longer to process and approve a loan application. Eligibility checks could take up to a few months. 
• Potential for Collateral: Banks frequently require collateral, which means the business property could be at risk if repayments aren't met.

SBA Loans

Sponsored by the U.S. Small Business Administration, SBA loans are specifically designed to empower small businesses. The SBA may provide favorable terms and conditions that might not be available through conventional banking channels.

SBA loans are renowned for their flexibility in loan amounts, with some programs offering loans as little as $50,000 to $5 million. Interest rates for SBA loans are usually competitive, ranging from 2.25% to 4.75%. Depending on the real estate's purpose and the specific SBA program, terms can stretch up to 25 years, providing businesses with ample time to manage repayments.

One standout feature of this financing option is that the SBA guarantees that a significant portion of the loan will be repaid, even in the event of borrower default. This backing can cover up to 85% of the loan, thus reducing the risk for lenders. The end result? More favorable terms and conditions for businesses than they might find with conventional loans.

In addition, SBA loans are preferred for the following reasons: 

• Extended Repayment Terms: These longer durations translate into manageable monthly payments, especially for high-cost real estate investments. 
• Lower Down Payments: Entering the real estate realm can be more accessible with the reduced down payment requirements of SBA loans. Typically, the SBA requires a 10% downpayment. 
• Competitive Interest Rates: Thanks to the SBA’s guarantee, borrowers may be eligible for lower interest rates.
• Mentoring and Education: The SBA offers resources, training, and mentoring services, which can be invaluable for businesses, especially newer ones.

Equally important to consider are the downsides of SBA loans. Before applying for one, businesses should be aware of the following:

• Strict Use of Funds: SBA loans usually come with restrictions on how you can use the loan proceeds. Funds must typically be used for the purposes stated in the application, limiting flexibility.
• Personal Guarantee: Most SBA loans require the business owner or major stakeholders to provide a personal guarantee. This means if the business defaults, the guarantor's assets could be at risk.
• Extensive Documentation: Beyond the standard loan application, businesses might need to provide additional documents like business plans, financial projections, or detailed market analyses.

Construction Loans 

Tailored specifically for the development or construction of new buildings or significant renovations, construction loans are an excellent fit for businesses eager to build from the ground up or revamp existing structures.

The average loan amount can vary widely depending on the scope and scale of the project, usually ranging between hundreds of thousands to tens of millions of dollars. Interest rates on construction loans tend to be slightly higher than standard commercial mortgages, primarily because of the inherent risk involved in funding a project that's yet to be completed. Rates may be between 4% and 12% but can be higher based on the borrower's creditworthiness.

Since these loans are designed to cover new buildings or renovations, terms usually last only for the duration of the construction – typically 12 to 18 months.

Down payments for construction loans are often heftier, ranging from 20% to 30% of the project cost. As for collateral, the future property and the construction itself act as the collateral. 

Construction loans can be ideal for businesses looking to upgrade or build their facilities from scratch. Here are some additional benefits: 

• Tailored Funds Disbursement: Lenders release funds in stages, matching the progression of the construction. This staged funding ensures money is used efficiently, reducing waste.
• Flexibility: Construction loans can be customized to fit specific project needs, accommodating unforeseen expenses or changes in the project scope.
• Potential for Higher Loan Amounts: Because the finished project's value can often exceed the construction costs, businesses may secure more substantial amounts compared to traditional loans.

As always, there are downsides to consider with any financing option. Here are some associated with construction loans:

• Higher Interest Rates: The risks involved with unfinished projects translate to higher interest costs compared to other financing options.
• Stricter Scrutiny: Lenders will require detailed construction plans, budgets, and timelines, demanding more documentation than other loans.
• End Financing Required: Once the project concludes, businesses usually need to secure another loan (or convert the existing one) to establish long-term financing.

Real-Estate-Secured Loans 

For business owners wanting to grow their operations but seeking more competitive rates, real-estate-secured loans present a compelling option. Essentially, these loans use real estate as collateral.

The loan amount is generally based on a percentage of the property's appraised value. Commonly, businesses can expect to borrow anywhere from $100,000 to several million dollars. However, most lenders will require a down payment of roughly 20% to 40% of the property’s value.

Interest rates for real-estate-secured loans are typically competitive, though they can fluctuate based on factors like the loan's duration, the general economic climate, and the business's creditworthiness. Rates can range from 4% to 10%. The length of these loans can span between five and 20 years. 

Real-estate-backed loans are often sought after for the following benefits they offer:

• Competitive Rates: Due to the collateral involved, these loans often come with more favorable interest rates compared to unsecured loans.
• Flexibility in Use: Funds from these loans can be used for various purposes, from purchasing new property to renovating existing spaces.
• Higher Borrowing Limits: With the property as security, lenders may be willing to loan a larger amount than they would with other types of loans.

However, consider the drawbacks of this financing option before applying: 

• Risk to Property: The most evident downside is the risk of losing the property if the loan isn't repaid. 
• Potential for Additional Fees: Some real-estate-secured loans come with additional costs, like appraisal fees, closing costs, or maintenance covenants.
• Stringent Approval Process: Given the substantial amounts often involved, the approval process can be rigorous, requiring thorough financial documentation and property checks.

How to Get a Commercial Real Estate Loan

If you’re ready to secure financing, you may be wondering how to get a commercial real estate loan. It involves meeting lender requirements and following specific steps tailored to your business needs.

We'll delve deeper into these aspects, ensuring you're well-prepared for this financial venture.

Requirements

Requirements for a commercial loan for real estate often vary by lender. However, securing a real estate loan often necessitates the following:

• A robust business credit history and personal credit score. For the primary business owner, a personal credit score in the high 600s or above is often preferred, although the exact score can vary based on the bank and the loan amount.
• Proof of business profitability. This includes presenting balance sheets, income statements, and tax returns, often from the last two to three years, to showcase the business's financial health.
• Operational history for at least two years.
• An annual revenue of $250,000 or more for certain commercial real estate loans. 
• A down payment, which can range from 10% to 25%.
• An appraisal of the real estate to ensure it aligns with the loan amount.

9 Steps to Qualify For a Commercial Loan

If you're wondering how to qualify for a commercial loan, this step-by-step guide will walk you through the process:

1. Determine Your Business Needs: Begin by clarifying why you need the real estate loan. Whether it's for purchasing a new property or renovating an existing one, having a clear objective can streamline your loan application process.
2. Review Your Financial Health: Lenders will want a comprehensive picture of your business's financial standing. Gather essential documents such as balance sheets, income statements, and tax returns from recent years. This data gives lenders insight into your ability to repay the loan.
3. Check Your Credit Score: A strong business and personal credit score can enhance your chances of approval. Higher scores can also earn you more favorable loan terms.
4. Calculate Debt-to-Service Coverage Ratio: This is a key metric lenders use to evaluate a borrower's ability to cover loan payments from business income. Use a debt-to-service-coverage ratio calculator for small businesses to get a precise estimate. Ideally, this ratio should exceed 1.25, indicating you have adequate income to manage the loan payments and other related expenses.
5. Select the Right Loan Type: Different real estate loans cater to varied business needs. From traditional bank loans to SBA loans or construction loans, research the options and determine which aligns best with your objectives.
6. Prepare a Business Plan: Especially if you're a newer business or planning an expansion, lenders will want to see a robust business plan that outlines your growth strategies, projected revenues, and other financial details.
7. Appraise Your Property: If you're using the loan to buy new property or leveraging an existing one as collateral, an appraisal will be necessary. This ensures the loan amount aligns with the property's value.
8. Submit Your Application: With all documents in place, submit your loan application to your chosen lender. Be sure to promptly provide any additional information they may request.
9. Await Approval: Once submitted, lenders will review your application. This phase can vary in duration based on the loan type and specific lender. Stay patient and proactive, addressing any queries that arise during this period.

FAQ on Commercial Real Estate Loans

If you still have additional questions regarding commercial property financing for real estate, we have the answers. 

How Do I Determine the Right Type of Real Estate Loan for My Business?

Choosing the right loan depends on your business needs. Factors to consider include the purpose of the loan (purchase, construction, or refinancing), loan duration, interest rates, and repayment structure. Consulting with a financial advisor or lender can also provide guidance tailored to your specific situation.

Do I Always Need to Provide Collateral for a Commercial Real Estate Loan?

In most cases, yes. Lenders typically require collateral as a form of security. The commercial property being financed often serves as this collateral. If the borrower defaults, the lender can seize the property to recover the funds.

How Long Does the Loan Approval Process Usually Take?

The duration varies based on the type of loan and specific lender. However, for traditional commercial real estate loans, the process can range from a few weeks to several months. Factors influencing this timeline include the completeness of your application, property appraisal, and the lender's internal review procedures.