Investing in commercial real estate is a big move. Whether you are buying properties as an investment or buying a property to operate your business, you will want to understand how commercial real estate loans work. We’ll provide a brief overview of the important information you need to know about commercial mortgages, how they work, and the different types of loans that are available.
What Is a Commercial Mortgage?
A commercial mortgage is a business loan that lets you buy commercial properties, including office space, factories, retail space, multi-family units, business properties, or vacant land. Most businesses use commercial mortgages to buy property, choosing from a variety of financing methods secured by liens against the property by the lender.
Commercial mortgages are typically used for buying:
- business property
- land for development
- a property to use as a business
- rental properties
Businesses can also use commercial mortgages to unlock the equity in properties they already own, using buildings as collateral.
Lenders include banks and credit unions, asset-backed trusts, government organizations, private financial institutions, and other investors.
Commercial Loans vs. Home Mortgages
Commercial mortgages differ greatly from residential mortgages. Many types of loans have significantly shorter repayment schedules and more stringent qualifying requirements. For example, home mortgages have loan-to-value ratios that can run as high as 95% to 100%, while commercial mortgages generally fall into the 65%-80% range.
Interest rates are also higher than residential loans and amortization periods are generally longer as well. A residential mortgage amortizes over the life of the loan so it is fully repaid at the end of the term. A commercial mortgage might use an amortization schedule over 30 years while the actual term is only 7 years. In this case, buyers would pay a fixed amount during the term, followed by a balloon payment at the end of the term to pay off the loan in full.
Unlike home mortgages, commercial loans may also have restrictions on prepayments and include penalties or prohibitions on prepayment. For example, exit penalties might include:
- Penalty fees based on the remaining term
- Interest guarantees even if the loan is paid off early
- Requiring substitution of collateral (defeasance)
There may also be a lockout period, stating the borrower cannot pay off the loan before a specific time to ensure lenders receive the anticipated yield.
Different Types of Commercial Mortgages
There are several different types of commercial mortgages. Depending on the type of business and your financial situation, one type of loan may work better for you.
Term loans for commercial real estate require repayment of a fixed amount on a defined repayment schedule. It will have a set maturity date and amortization schedule. Options include:
- Conventional, long-term real estate mortgages (15–30 years)
- Conventional, short-term real estate mortgages (1-5 years)
- 7A loans from the US Small Business Administration (Up to 25 years)
- 504 loans for small businesses that own or occupy most of their property (10-20 years)
Debt-Service Coverage Ratio (DSCR) Loans
DSCR loans can be used to purchase commercial real estate and multifamily properties. They are a unique type of loan based on the revenue generated from the business monthly compared to the debt service payments.
These loans are a great route for those pursuing commercial real estate and are based on future cash flow, so they are often easier to qualify for compared to other types of loans. Rather than relying on personal assets, mortgages are based on property income.
Bridge loans provide short-term financing that allows buyers to move forward on deals until they can find a more permanent financing solution. They are often used by businesses that are waiting to free up funds from selling another commercial property.
Bridge loans generally have short repayment terms, typically 12-18 months.
Other Types of Commercial Mortgage Loans
There are other commercial mortgage loans available, including:
- Vacation rental properties or fix-and-flip loans
- Ground-up construction loans
- Renovation and rehab loans
- Long-term rental loans
- Vacant land loans
Loans can be used for acquisition, construction, redevelopment, or refinancing.
Qualifying for Commercial Loans
Each type of loan, and each lender, will have slightly different qualifications. Lenders will generally consider:
- The creditworthiness of the owner/borrower
- Financial statements and tax returns
- Loan-to-value ratios
- Debt-service coverage ratio
- Property collateral
- Property rental income (if applicable)
- Down payment
As part of the underwriting process, lenders will do a commercial appraisal to estimate the value of the property. Commercial loans are not backed by the government, such as Fannie Mae or Freddie Mac back residential loans. So, lenders will typically dig more deeply to make sure buyers or businesses are qualified for the loan. So, both business credit scores and personal credit scores may play a role in whether someone qualifies for a commercial mortgage.
Lenders may also require a personal guarantee from the business owner. In case a business defaults, the owner would be liable for loan repayment. As such, the owner (guarantor) would need to have enough personal assets to qualify for the loan.
Secure Your Future
Before signing up for a commercial mortgage, it’s important that you understand how they work and the various options available. Finding the right commercial mortgage can help you grow your business and secure your future.