What is a Commercial loan?

Commercial real estate (CRE) is income-producing property used solely for business (rather than residential) purposes. Examples include retail malls, shopping centers, office buildings and complexes, and hotels. Financing—including the acquisition, development and construction of these properties—is typically accomplished through commercial real estate loans, secured by liens on the commercial property.

Here, we take a look at commercial real estate loans and what lenders look for.

How do Commercial loans work?

Commercial real estate loans are designed to help borrowers purchase new commercial property, renovate income-producing properties, or refinance real estate debt on a property they already own.

Although commercial real estate loans work similarly to traditional mortgage loans for individuals, there are some key differences that small business owners should understand.

Loan-to-Value Ratio

The loan-to-value ratio, LTV for short, is a metric that lenders use to determine how much money they can loan. More specifically, they calculate it by dividing the loan amount by the property’s value.

With commercial real estate loans, lenders typically want an LTV of around 75% to 80%, according to the National Association of Realtors (NAR). Which means, you either need to purchase an undervalued property or have a 20% to 25% percent down payment before you approach a lender if they are using LTV to determine loan amount.

That said, the NAR also found that just 60% of commercial real estate lenders used LTV as a criterion for determining how much a business can borrow. The remaining 40% used what’s called the debt service coverage ratio, or DSCR for short.

The DSCR is used to measure the ability of a borrower to pay its current debt obligations with its existing cash flow. To calculate it, you divide your annual net operating income by your total debt payments for the year. According to the NAR, the median DSCR is 1.25.

Personal Guarantee vs. Non-Recourse Loans

In a commercial real estate loan, the lender will use the property as collateral for the debt. But in some cases, it may also require a personal guarantee.

Depending on how long you’ve been in business, your company may not have the financial track record required by the lender to qualify for a commercial real estate loan. In this scenario, the lender may ask the principals or owners to guarantee the loan. This means that if your business can’t repay the debt, you as the borrower agree to be personally liable for making the monthly payments, in the event that the property itself doesn’t fully cover the amount you still owe.

In another scenario, the lender may not require a personal guarantee and simply use the property itself as the only means to recover the loan funds should you be unable to keep up with your mortgage payments. This is sometimes called a non-recourse loan because the lender cannot get additional money from the business principals or owners if the property doesn’t fully cover the amount owed.

Pros of Commercial Real Estate Loans

Many options available
Variety of terms
Flexible repayment terms
Tax breaks
Commercial real estate loans offer more diversity and more options than a personal real estate loan or mortgage may afford. This includes repayment terms, interest rates, and payment schedules that can work with your business’ schedule and budget. You’ll also enjoy the tax breaks that come with property ownership, and building equity can add value to your business as you continue making on-time payments.

Cons of Commercial Real Estate Loans

High barrier to entry
Long approval time
Riskier to lenders

High upfront cost
Loss of capital
There are, unfortunately, a number of drawbacks when it comes to commercial real estate loans. Because of economic fluctuations, they are also viewed as being riskier by lenders, which may lead to unfavorable terms depending on the economic climate and your financials.