Commercial loans exist to finance property that’s used for business-related purposes, such as shopping malls, warehouses, apartment complexes and office buildings. A commercial loan can be used to buy new property, renovate existing income-producing property or refinance debt on a commercial property you already own.
Often, commercial loans are made to a business entity such as a corporation, developer or trust, though an individual can borrow one as well. Most of these loans require that the property is owner-occupied, meaning your business resides in at least 51% of the building.
Commercial real estate loans work similarly to mortgage loans for personal real estate. One of the main differences is that the loan is secured by a lien against the commercial property rather than a residential property. A lien is a legal claim to a property that can be used as collateral if a loan goes unpaid. In the case of a commercial loan, the lender removes the lien once the loan is paid off.
The exact terms of a commercial real estate loan depend on the specific type of loan, lender, property financed and more. Some common types of commercial real estate loans include:
Credit
Your personal credit score gives lenders an idea of your track record with borrowing money in the past. A history of paying back your debts on time and in full, for instance, usually results in good credit. Missed payments, accounts in collections and other problems can cause your credit score to drop.
Similarly, businesses can have their own credit scores. The FICO Small Business Scoring Service, for example, rates the credit risk of small businesses using a three-digit score ranging from 0 to 300.
The score needed to qualify for a commercial real estate loan depends on the particular lender, though a score in the 200s is generally considered good. Keep in mind that your personal credit score may also be considered along with your business score.
Loan-to-Value (LTV) Ratio
In residential mortgage lending, the loan-to-value ratio is used to measure the total value of a mortgage compared to the total value of the property. With a traditional mortgage, it’s possible to borrow up to the full value of your home (depending on the specific loan program), for an LTV of 100%.
With commercial real estate loans, however, lenders prefer a maximum LTV of 75% to 80%. This means you may need to put at least 20% to 25% (or more) down to be approved.
Debt Service Coverage Ratio (DSCR)
Lenders want to know that you generate enough income to handle new real estate debt. For residential mortgages, lenders look at your debt-to-income (DTI) ratio.
With commercial loans, however, lenders look at a business’s debt service coverage ratio. This measures a borrower’s ability to pay their debts based on the business cash flow. It’s calculated by dividing your annual net operating income by your total annual debt payments. The higher your DSCR, the higher your approval odds.
Personal Guarantee
In most cases, the property being financed serves as the collateral for a real estate loan. In the case of a commercial real estate loan, however, the borrower may be required to make a personal guarantee as well.
This means that if the business can’t make the loan payments and liquidating collateral (i.e., foreclosing on the property) doesn’t produce enough money to repay the loan, the borrower is personally responsible for covering the difference.
Commercial real estate loans work similarly to mortgage loans for personal real estate. One of the main differences is that the loan is secured by a lien against the commercial property rather than a residential property. A lien is a legal claim to a property that can be used as collateral if a loan goes unpaid. In the case of a commercial loan, the lender removes the lien once the loan is paid off.The exact terms of a commercial real estate loan depend on the specific type of loan, lender, property financed and more. Some common types of commercial real estate loans include:
Interest rates on commercial real estate loans tend to be higher than those for residential loans. They’re typically about 0.5% to 1% higher than the 30-year prime rate for mortgages.
Currently, rates range from 3% to 20%, depending on the exact type of loan, property and your personal financial profile. The repayment term may also be shorter for commercial real estate loans, meaning they can be a bit more expensive than residential loans.
Also, like residential mortgages, commercial real estate loans come with closing costs. Typically, these range between 3% and 5% of the amount borrowed. In the case of SBA loans, you’ll need to pay a guaranty fee of up to 3.75%, depending on the amount borrowed.
Credit
Your personal credit score gives lenders an idea of your track record with borrowing money in the past. A history of paying back your debts on time and in full, for instance, usually results in good credit. Missed payments, accounts in collections and other problems can cause your credit score to drop.
Similarly, businesses can have their own credit scores. The FICO Small Business Scoring Service, for example, rates the credit risk of small businesses using a three-digit score ranging from 0 to 300.
The SBA uses the FICO SBSS when evaluating 7(a) loan applicants, and requires a minimum score of 140. Some banks also look at this score, such as U.S. Bank and Huntington National Bank.
The score needed to qualify for a commercial real estate loan depends on the particular lender, though a score in the 200s is generally considered good. Keep in mind that your personal credit score may also be considered along with your business score.
Loan-to-Value (LTV) Ratio
In mortgage lending, the loan-to-value ratio is used to measure the total value of a mortgage compared to the total value of the property. With a traditional mortgage, it’s possible to borrow up to the full value of your home (depending on the specific loan program), for an LTV of 100%.
With commercial real estate loans, however, lenders prefer a maximum LTV of 75% to 80%. This means you may need to put at least 20% to 25% (or more) down to be approved.
Debt Service Coverage Ratio (DSCR)
Lenders want to know that you generate enough income to handle new real estate debt. For residential mortgages, lenders look at your debt-to-income (DTI) ratio.
With commercial loans, however, lenders look at a business’s debt service coverage ratio. This measures a borrower’s ability to pay their debts based on the business cash flow. It’s calculated by dividing your annual net operating income by your total annual debt payments. The higher your DSCR, the higher your approval odds.
The median DSCR among approved commercial real estate loans was 1.25 as of 2019, according to the National Association of Realtors Commercial Lending Report. This means if you borrowed $100,000, your net operating income should be $125,000 per year.
Personal Guarantee
In most cases, the property being financed serves as the collateral for a real estate loan. In the case of a commercial real estate loan, however, the borrower may be required to make a personal guarantee as well.
This means that if the business can’t make the loan payments and liquidating collateral (i.e., foreclosing on the property) doesn’t produce enough money to repay the loan, the borrower is personally responsible for covering the difference.
