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Business owners often use commercial real estate loans if they have plans to expand or renovate. These loans are different from other types of small business loans, functioning more similarly to a residential mortgage.
Commercial real estate loans explained
Similar to taking out a home mortgage, you can also take out a mortgage when buying commercial property. Commercial real estate lending helps business owners finance the purchase or renovation of commercial property, such as:
- Office buildings
- Retail or shopping centers
- Apartment buildings
- Industrial buildings
Most commercial real estate loans require the property to be owner-occupied — meaning the business needs to physically reside in at least 51% of the building. If the property won’t be majority owner-occupied, borrowers may have to look for an investment property loan instead.
Terms and rates can vary by the lender and property being financed (see our guide on average commercial real estate loan rates for a better idea). Interest rates may be fixed or variable, and down payments on commercial properties typically range from 10% to 30%, with repayment terms as short as five years and as long as 25. Some loans are fully amortized — each monthly payment will be the same until the loan is paid off — whereas others might have interest-only payments with a final balloon payment at the end of the term.
Types of commercial real estate loans
A variety of commercial real estate loans exist, including bank loans, Small Business Administration (SBA) loans and bridge loans. We take a look at some of these options below.
Traditional commercial mortgage
Like a residential mortgage, a commercial loan is secured by the property being purchased. Beyond that, terms can vary by the lender. Some banks will make fully amortized loans with long terms up to 20 years and loan-to-value ratios typically up to 80%. Other banks may have interest-only loans with terms of 10 years and loan-to-value ratios of 65%.
Qualifying for a traditional commercial real estate loan is generally more difficult than other types of commercial loans. Banks want to see business owners with good personal credit and a high debt service coverage ratio (DSCR) — a high ratio shows lenders that your business is generating enough revenue to repay the loan. To calculate your DSCR, you would divide your annual net operating income by your annual debt payments; lenders typically look for a score of at least 1.25.
Despite the strict requirements, traditional mortgage loans tend to carry lower interest rates compared to some alternative lending products — usually within a few percentage points of a prime rate, such as the Wall Street Journal (WSJ) Prime Rate.
SBA 7(a) loan
The SBA’s flagship loan, the 7(a) loan, can be used to purchase land or buildings, construct new property or renovate existing property, provided the real estate will be owner-occupied. Through this program, you can borrow up to $5 million through an SBA-affiliated lender.
The interest rate cap on a 7(a) loan can be fixed (11.25%), variable (8%) or a combination of the two. The rates are based on the lowest prime rate, the 30-day LIBOR rate or the SBA optional peg rate. Repayment terms for 7(a) loans used for real estate can go up to 25 years. These loans are fully amortized.
SBA 504 loan
Beyond the 7(a) program, the SBA offers loans specifically for owner-occupied real estate or long-term equipment purchases. These loans, called 504 loans, are composed of two different loans: One comes from a Certified Development Company (CDC) for up to 40% of the loan amount and the other from a third-party lender for 50% or more of the loan amount. You, the borrower, will be responsible for putting at least 10% as a down payment. The CDC portion of the loan can range from $5 million to $5.5 million, meaning the entire project being financed can be upwards of $10 million or more. The minimum loan amount you can apply for is $25,000.
Interest rates on the CDC portion are fixed and can range from 2.623% to 2.887%, as of May 2021. The interest rate on the third-party loan can be fixed or variable and is subject to a maximum cap — 6% above the New York prime rate or the maximum interest rate in a given state, whichever is less. The maximum term is 25 years.
Conduit loans are securitized commercial mortgages, meaning the lender pooled together various commercial real estate loans and sold them to investors on a secondary market. Conduit loans behave a little differently than traditional commercial real estate loans. Paying off your loan early, for example, can incur prepayment penalty fees. Flexible requirements may also help business owners that wouldn’t otherwise qualify for a traditional mortgage loan.
Conduit lenders will generally finance amounts between $1 million to $3 million and up to $50 million. Conduit loans, on average, have loan-to-value ratios of 75% with terms of five to 10 years and 25- to 30-year amortization periods. Each monthly payment will be the same until a final balloon payment at the end of the loan term. Interest rates on conduit loans are typically fixed and lower than rates on a traditional mortgage.
Commercial bridge loans
Bridge loans offer quick financing used to "bridge the gap" until long-term financing can be secured for the commercial property. A business owner, for example, may use one to compete with all-cash bidders on a property, then refinance to a long-term loan after securing the property. Generally, most bridge loans come with very short terms (often six months to three years), and must be paid off in full after maturing. Interest rates on bridge loans are typically a few percentage points higher than the going market rate.
Commercial bridge loans are more readily available from alternative lenders than banks and credit unions. Since shorter terms increase the lender’s risk, qualifying for a bridge loan can be challenging. Business owners typically need to have strong credit and a low debt-to-income ratio to be approved. Down payments generally range between 10% and 20% and often close more quickly than conventional real estate loans.
Soft and hard money loans
Hard money loans are similar to bridge loans, with the primary differences being that most hard money loans are made by private lenders or investors and may have higher down payment requirements. Like bridge loans, hard money loans have short terms, higher interest rates and interest-only payments. They are also easier to qualify for and faster to fund than a traditional mortgage.
Soft money loans are a hybrid between a hard money loan and a traditional mortgage. Unlike hard money lenders that prioritize property value, soft money lenders place greater weight on creditworthiness. A higher credit score may secure a lower interest rate than a hard money loan. Terms can range from six months to a few years. And, like hard money loans, soft money loans are also quick to close. They can be a good option for borrowers who need to move quickly on a property, but don’t want to pay the high rates that come with a hard money or bridge loan.
Which commercial real estate loan is right for your business?
Here are a few tips that can help you choose the best commercial real estate loan for your needs and background:
Determine how quickly you need the funds.
If you need fast funding — to compete with an all-cash buyer on a commercial piece of property, for instance — an SBA loan or traditional commercial mortgage loan may not work, as time to funding for these financing options can sometimes take months. An alternative commercial real estate loan that can be funded within a few days, like a commercial bridge loan, may be a better option.
Use your qualifications to narrow down your options.
Your background and qualifications will narrow down the financing options you can realistically obtain. If you have good credit and your business has a high debt service coverage ratio, then you may qualify for a traditional commercial mortgage loan with favorable rates and longer terms. Bad credit applicants may find more success with a hard money lender with lenient requirements — just be mindful of high interest rates.
Don’t take the first offer you’re given — shop around with different lenders to compare rates and terms. Many business owners start with lenders they already have relationships with, such as the institution where they do their business banking. Regional and local banks are another good starting point, since these institutions tend to better understand the local market. When applying, be wary when lenders make "soft" versus "hard" credit inquiries — the latter can harm your credit score.