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Real estate remains one of the most lucrative investment options, especially when it comes to commercial properties. However, securing the necessary funding for such investments can be challenging. The terms, interest rates, and processes involved are unique to the commercial sector. That's why we've put together a comprehensive guide designed to help you understand commercial real estate financing options and how you can fund your commercial property investment.
Understanding Commercial Real Estate Financing
Commercial real estate (CRE) financing deals with the financial aspects of acquiring and managing commercial properties. These can include office buildings, retail spaces, warehouses, and multifamily residential buildings. Simply put, it's the financial vehicle that allows businesses and investors to purchase, improve, or refinance commercial properties.
Unlike residential real estate, commercial real estate often involves larger transactions, complex terms, and can be riskier. However, it also presents opportunities for higher returns, making it an attractive option for many investors.
Understanding Commercial Real Estate Loans
Commercial real estate loans are a subset of commercial real estate financing. These are mortgages secured by liens on a commercial property. The loans are typically used to purchase, renovate, or refinance commercial properties.
Commercial property loans differ from residential loans in that they often have shorter amortization periods and a balloon payment at the end of the term. They also typically require a higher down payment. In addition, commercial lenders take into account the property's potential income and the borrower's creditworthiness to determine loan terms1.
The Changing World of Commercial Real Estate Loans
According to Eddie Blount with Pinnacle Financial Partners, commercial loans look a lot different now than they did two to three years ago. At that point, the interest rate may have started with a 3 or a 4. These days, it will likely start with at least a 6 or a 7.
In turn, Eddie says that means you'll need an even higher down payment than during a lower rate environment. "Whereas you may have been able to buy something with 20-25% down before, lenders may now require more like 30-40%, due to the payment being higher.
There is also more perceived risk in the market now than a few years ago. For instance, the world is still waiting to see how successful the 'return to office' movement will be. There’s a lot of resistance from people who learned to enjoy working from home. If you have an office building, vacancies are much higher than they used to be. The same is true for retail. People got really comfortable ordering stuff on Amazon when they didn't want to get out, and that's hurt a lot of the retailers. Restaurants have changed as well. Since workers are harder to find, many are doing exclusively takeout now instead of sit down, and some of them have closed up too. It's just a different world."
All of this means that there is a lot of pressure on banks to be more selective these days in their commercial real estate loans and to structure them more conservatively.
The Importance of Commercial Real Estate Financing
Commercial real estate financing plays a crucial role in the business world. It allows businesses to operate, expand, and invest without tying up significant capital in real estate. For investors, commercial real estate financing opens up opportunities to invest in larger, more lucrative properties that wouldn't be possible with personal financing alone.
Eddie offers an example. "If you had $500,000 to invest in real estate, you could take all of that and buy a $500,000 property. Then you'd receive the cash flow that one $500,000 property generates. If you took that $500,000, split it, and put $250,000 equity in a property and $250,000 debt on that property, then you could go do that twice. You would have two properties for that same $500,000, and you'd have the income from both of those. You get more income normally if you have more properties."
Moreover, commercial real estate loans can provide tax benefits. Interest and depreciation on commercial properties can often be deducted from your taxable income, potentially leading to significant tax savings2.
Most Common Commercial Real Estate Financing Options
There are a variety of ways investors can finance their next commercial real estate investment. Eddie walks us through some of the most common types of commercial real estate financing options.
This method of financing, Eddie notes, is clearly the easiest. "If you're just sitting on a pile of cash, and you don't want to have to involve a bank or worry about appraisals and stuff like that, cash is certainly easy."
2. Traditional Commercial Mortgages.
These are standard loans offered by banks and credit unions. They are the ones that typically require a 30-40% down payment and have terms ranging from 5-20 years3. Eddie says that for smaller amounts, community banks are often the best place to start when looking for a commercial real estate lender. They may do 80-85% financing because they're willing to be more aggressive in trying to get the smaller deals than the big banks will be.
3. Institutional Financing.
This type of financing is for larger loan amounts, such as tens of millions of dollars.
4. Private Money Loans.
These types of loans come from private investors or private investment companies and usually have shorter terms and higher interest rates than traditional loans.
5. Friends and Family.
Eddie advises that if you're just starting out as a real estate investor, going to friends and family for financing is often the smartest move to make. Banks usually want to see an investor with experience, but those who know you best may be more willing to take a chance on you and your investment. It's also a chance for them to make some money if your deal includes paying them back with interest.
Other Types of Commercial Real Estate Financing
Here are some other loan types that can be considered as well.
1. Small Business Administration (SBA) Loans.
These are loans backed by the Small Business Administration. They offer longer repayment terms and lower down payments. This makes them an attractive option for small businesses. The SBA's most commonly used loan program is the SBA 7 (a) loan. The maximum loan amount is $5 million. According to the SBA, "Key eligibility factors are based on what the business does to receive its income, its credit history, and where the business operates." Another option is the SBA 504 loan program. This loan "provides long-term, fixed-rate financing of up to $5 million for major fixed assets4."
Eddie notes that SBA loans can only be used for owner-occupied properties. Those are properties where the business owner taking out the loan uses at least 51% of the space for their business. The rest of the space can be leased out to another business.
2. Hard Money Loans.
These are short-term loans typically used for quick real estate transactions or when traditional financing isn't available. Often considered to be a bridge loan, they are secured by real property and often have higher interest rates and fees and usually have a shorter repayment period or term of the loan. In turn, it's typically easier to qualify for this type of loan, and the time it takes to get approved is much faster5.
This is a relatively new form of financing used to purchase commercial real estate. It's where you can raise money from a large number of people, typically through a crowdfunding platform. You would then be known as the sponsor and individual investors will contribute to your project. Those investors will share in any profits from rent generated by the property6.
4. Real Estate Investment Trusts (REITs).
These are companies that own, operate, or finance income-generating real estate. They offer investors a way to invest in real estate without having to buy a property7.
5. Owner or Seller Financing.
In these situations, the property seller finances the deal. The buyer then makes payments to the seller. This type of loan may be helpful if you can't qualify for a commercial real estate loan or if you want to simply avoid dealing with another type of lender8.
How to Choose the Right Commercial Real Estate Loan
Choosing the right commercial real estate loan depends on your unique situation – your financial status, your investment goals, the property type, and the market conditions. Here are some factors to consider.
1. Loan Terms.
Consider the loan's interest rate, term length, and repayment schedule. Some loans offer fixed interest rates, while others have variable rates. Also consider whether it's an interest-only loan or if it includes principal repayment.
2. Down Payment.
Some loans require larger down payments than others. If you're a small business owner or a first-time investor, you might want to opt for a loan with a lower down payment requirement.
Some loans offer more flexibility than others. For instance, some lenders may allow you to make early repayments without penalty, or they may offer the option to extend the loan term if needed.
4. Ease of Approval.
Some loans are easier to qualify for than others. If you have a lower credit score, or if you're a first-time investor, you might want to consider loans that have less stringent approval criteria.
Key Factors to Consider With Commercial Real Estate Financing Options
When considering your commercial real estate financing options, Eddie gives several key factors that are crucial to evaluate.
1. Tenant Quality.
According to Eddie, if you're investing in commercial real estate for purely investment purposes, your main consideration when thinking about financing would probably be your tenant quality. "You're not just buying a property, you're buying a cash flow from the tenant. If your tenant closes up, and you stop getting their rent check, the bank is still going to expect their mortgage payment every month.
2. Credit Score.
Eddie says that while a good credit score is one of many factors considered when loans are made, having a bad credit score can disqualify you immediately. However, it's important to note that commercial lenders normally look at the individual borrower's credit score, not that of the business. "Even if the borrower has an LLC or a company that they are running, we'll pull a personal credit report on them." Eddie explains that most lenders consider at least 700 to be an acceptable credit score. "You're probably not going to get a lot of questions about your score if it's 700 or over. If it's in the low 600s, you're probably going to have a hard time."
3. Down Payment.
Most commercial real estate loans require a down payment of between 30-40%.
4. Debt Service Coverage Ratio (DSCR).
This is a measure of your ability to cover your loan payments with your property's net operating income. Eddie says that when the amount of the loan is above $50,000-$100,000, banks will be looking at this carefully.
5. Loan-to-Value (LTV) Ratio.
The Consumer Financial Protection Bureau says that the loan-to-value ratio is a measure that compares the amount of your commercial mortgage loan with the appraised value of the property. The higher your down payment, the lower your LTV ratio. Similar to debt service coverage, Eddie points to this as another important factor for loans over $100,000.
6. Property's Income Potential.
Lenders will look at the potential income the property can generate to determine if it’s enough to cover the loan payments.
7. Business Financials.
If you're a business owner trying to get a commercial loan, lenders will likely look at your business's financials. This will probably include revenue, profit, and cash flow.
8. Develop and Nurture Good Relationships.
Eddie says as a real estate investor, your relationships are extremely important. He categorizes those with bankers, realtors, and other investors as among the most crucial to your success. "from the banking side of things, I'm a lot more likely to do loans for clients who I know well, who've borrowed from me and paid me back."
The Process of Securing a Commercial Real Estate Loan
Securing a commercial real estate loan involves several steps.
- Prepare Your Financial Documents. You'll need to provide your financial information. This should include your credit score, income statement, balance sheet, and cash flow statement.
- Choose the Right Loan. Consider your investment goals, financial situation, and the property type to choose the right loan.
- Apply for the Loan. Once you've chosen a loan, you'll need to fill out an application and submit your financial documents. The lender will then review your application and decide whether to approve your loan.
- Undergo Due Diligence. If your application is approved, the lender will conduct due diligence, which includes a property appraisal, a title search, and a review of the property's financials.
- Close the Loan. If everything checks out during due diligence, you'll proceed to closing, where you'll sign the loan documents and receive the loan funds.
Expert Tips for Successful Commercial Real Estate Financing
To successfully navigate commercial real estate financing, keep the following tips in mind.
1. Thoroughly research and compare different financing options. Understand the terms and conditions of each loan, and choose the one that best fits your needs.
2. Maintain a strong credit history. This can increase your chances of securing a loan with favorable terms.
3. Work with experienced professionals. This can include real estate brokers, attorneys, lenders, and financial advisors who can guide you through the process and help you avoid potential pitfalls.
4. Have a solid business plan. This can demonstrate to lenders that you have a clear strategy for the property and can repay the loan.
Bottom Line on Commercial Real Estate Financing Options
The bottom line in considering financing options is to understand that purchasing commercial real estate can be a complex process, but with the right knowledge and resources, you can navigate it successfully. By understanding what the best commercial real estate loan options are, considering key factors, and following expert advice, you can secure the financing you need to invest in commercial property. The journey may be challenging, but the potential rewards can make it worthwhile.
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Our brokers and other partnering commercial real estate experts will be answering your questions every month through the Ask a Broker series. If you have a commercial real estate question that you want to be answered, we’d love to hear from you at firstname.lastname@example.org.
- Investopedia. Commercial Real Estate Definition and Types
- IRS. Rental Income and Expenses - Real Estate Tax Tips
- Investopedia. Commercial Real Estate Loans
- U.S. Small Business Administration. Loans
- Investopedia. Hard Money Loan
- Forbes. REITs Vs. Real Estate Crowdfunding: What You Need To Know
- Nareit. What's a REIT (Real Estate Investment Trust)?
- CREXI. What is Owner Financing for Commercial Property?
- Consumer Financial Protection Bureau. What is a loan-to-value ratio and how does it relate to my costs?