In this article, we explain how to obtain commercial real estate loans for the purchase of shopping centers, hotels, and other income-producing property. After reading this article, you should understand what you will need to qualify for a commercial real estate loan, what to expect in terms of typical interest rates and fees, and the how to apply for a loan.
Note: If you’re buying an investment or income producing property, we recommend reaching out to South End Capital. They are a flexible, experienced commercial real estate lender and can fund up to 70% of the purchase price.
Commercial Real Estate Loans: Where Can I Get One?
There are many types of lenders that issue commercial real estate loans. Large banks, small community banks, life insurance companies, and private “hard money” lenders are all in this business. Knowing which one to go to can make all the difference between getting an affordable loan and being rejected or biting off more than you can chew.
One simple tip to keep in mind is to go to a lender that’s suitable for the size of loan you want. As C-Loans puts it, “You usually won’t want to take a $200,000 commercial real estate loan request to a bank the size of Bank of America.
Conversely, you won’t want to take a $15 million commercial real estate loan request to the small Bank of the Northeast Corner of Tiny Town.” Banks can take several months to issue a commercial real estate loan.
Life insurance companies also make commercial real estate loans. They offer good rates but are very picky about what properties they will lend against. They usually only want in on the most desirable properties, and they require large down payments.
Private hard money lenders pool money from investors and are very active in the commercial real estate space. They charge higher rates than banks and life insurance but not by much, and they lend money more quickly than other lenders.
SmartBiz can get qualified borrowers funded in as little as two months. With loans up to $5,000,000 and terms as long as 25 years, they are changing people’s notion of what to expect when applying for SBA commercial real estate loans.
Will I Qualify?
Every lender has its own specific qualification criteria, but there are some general things to keep in mind. To qualify for a commercial real estate loan for an income producing property, you should have a property with good potential and a clear vision for the property’s success.
Clear Business Plan
To get a loan, you must prove to the lender that you understand the property you’re buying and can turn a profit. If you can convince the lender about this, things like your credit score and personal net worth become less important (particularly for higher end deals).
You should capture your vision in a business plan that includes a description of the property, a description of the market, and all the financials of the deal. Banks will be impressed by an organized “sponsor” (i.e. the prospective buyer) who has a clear vision and all necessary financial docs gathered in a single package. The specifics of your business plan will depend on the type of property you’re purchasing.
For example, if you want to buy a vacant property, your plan must detail how you plan to get tenants to fill up the property. You must convince the bank that your property will have a steady income stream so that you can afford the monthly loan payments. If you are buying a property that already has tenants, you will need to show that you know the status of each tenant’s lease and have a plan for renewals and replacing outgoing tenants with new ones.
The general economic climate and area where your property is located are also important. If you’re planning to buy property in an economically distressed area, you have to clearly plan out how you will attract tenants and customers. Otherwise, the bank may hesitate to give you a loan.
Credit Score & Personal Financial History
The importance of individual credit scores and personal net worth for these types of loans depends on the size of the deal.
For smaller deals (under $3 million), banks will closely examine personal credit scores. You should ideally have a credit rating of 660 or greater. Over 700 further increases your chances of qualifying. Not sure what your credit score is? Check it for free.
Beyond your numeric credit score, your credit history should be positive as well. This means no bankruptcies in the last 7 years or foreclosures in last 3 years. You shouldn’t have open tax liens or judgments either. In some cases, your financial history can overcome a poor credit score. For instance, if your credit rating experienced a temporary decline due to a divorce, you may be able to explain that to a bank and still obtain a loan.
If you have a high personal net worth, it can help you get a loan that you otherwise couldn’t get. If you’re looking to buy a property with creditworthy tenants like a Walgreens or a Home Depot, then the lender knows the property is a safe bet and won’t give much thought to your personal net worth. If, on the other hand, you want a loan for a vacant shopping complex, your personal net worth may make the lender feel comfortable enough to issue the loan.
For large deals (over $3 million), lenders don’t care much about individual credit scores or individual net worth. They are more concerned with the property itself, the tenants, and the team behind the project. In addition, the more institutional you get, the less lenders care about individual credit scores. For instance, if a property management company, trust, or other commercial entity is the prospective owner of the commercial property, then that entity’s business credit score will be considered rather than personal credit scores.
Experience of the Management Team
A lender will look closely at the team that will be managing the property. Since you and your team will be calling the shots, they want to ensure that you collectively have the experience necessary to successfully run the property.
Does this mean you cannot get a loan if you don’t have decades of experience investing in commercial real estate? No. Experience matters more with income producing properties like shopping malls. If you already own a shopping mall, it will be a lot easier to get a loan for buying a second one. If you have no experience, you’ll have to show the lender you know what you’re doing by having a solid business plan and surrounding yourself with a qualified, experienced team.
Not sure whether to buy or lease? Check out our comparison guide: Buying vs Leasing Commercial Real Estate.
Lenders will have a third party appraise the property. They will also evaluate its income-generating capacity when determining whether to give you a loan and how much they can lend to you.
Down Payment and Loan to Value Ratio
Loan To Value (LTV) Ratio = Loan Amount Property Value
The LTV ratio compares the amount of your loan against the appraised value of your property. The LTV varies based on the type of commercial real estate you are trying to buy and the type of lender you approach. However, most banks want an LTV no higher than 70-80 %, and private lenders sometimes offer even less financing.
If a lender has an 80 % LTV ratio, that means it will issue you a loan for 80 % of the purchase price, and you must put the remaining 20 % down. The lower your LTV ratio, the better it is because it means you have more equity in your property, a smaller loan balance, and thus more capacity to pay the loan back in full.
Example: You want to buy a shopping center. The bank hires a third party appraiser (you typically have to pay the appraisal fees), who assesses the value of the property at $1 million. You only have $100K for a down payment and need to borrow the remaining $900,000 to purchase the building. This brings the LTV to 90 % ($900K / $1 Million). This is too high for most lenders. You will have to come up with at least another $100K of down payment before they will give you the loan.
The Debt Service Coverage Ratio (DSCR) weighs the income generating capacity of the property you’re buying against all your debt payments. It helps a loan officer determine if you will have the capacity to afford your loan payments.
DSCR = Annual Net Operating Income Total Annual Debt Payments
Calculating the DSCR depends on the net operating income of the commercial property you are planning to buy. For an income producing property like a shopping center, your rental income from tenants is what matters.
The denominator of the DSCR includes not just the balance on the loan you’re trying to get, but principal and interest payments on all of your loans. Lenders generally like to see a DSCR of 1.25 or higher. This gives you some breathing room if your business’ income takes a hit, so you ‘re not struggling to make your loan payments.
You want to buy a shopping complex with several tenants who will pay you rent. The predicted net operating income (gross annual income – annual expenses) of the shopping complex is $1 million. When you add up the annual payments on all of your loans (including the loan you’re applying for), they add up to $700,000. This gives you a DSCR of $1 Million / $700,000 = 1.43. This means that, after you make all your annual loan payments, you will be left with 43 percent of your profits. This places you in a great position to obtain the loan to buy the shopping center.
Collateral and Personal Guarantee (Recourse vs. Non-Recourse Loans)
When you obtain a loan to buy commercial real estate, the real estate itself secures the loan. Accordingly, coming up with sufficient collateral is usually not a problem for most borrowers. If you’re a credit risk, other collateral such as the business equipment or accounts receivables may also be required. You may also need to assign your rental income from your tenants to the lender as additional security. In that case, if you don’t pay back the loan, the lender can use the incoming rents to satisfy the loan payments.
In some cases, a personal guarantee may be necessary in addition to the real estate collateral. This means that if you don’t pay the loan, the lender can seize personal assets such as your car or home.
You may have to personally guarantee a loan for smaller deals, typically under $3-5 million. In addition, according to Investopedia, you may be asked to personally guarantee a loan if a commercial entity is the owner of the property, and that entity hasn’t built up a business credit score or a financial track record. For example, if you form a new LLC to buy a shopping center, you may have to personally guarantee the loan to make the bank comfortable enough to issue the loan.
Lenders use the term “recourse loan” to describe a loan that is backed by personal assets in addition to collateral. In other words, if you default on the loan and the proceeds of the real estate aren’t sufficient to repay the loan, the lender can come after your personal assets. If the bank has no security other than the real estate that collateralizes the loan, the loan is called “non-recourse.” Larger deals and projects that are led by well established commercial entities (e.g. property management companies) are more likely than smaller deals to be non-recourse because the lender vets the property’s income-generating capacity more thoroughly for larger deals.
Cost & Loan Terms
The average interest rate on a commercial real estate-backed bank loan is 5-10 %. Depending on the bank, these rates can be fixed, or they can vary based on the market.
Interest rates are higher for private hard money lenders. Expect 10 % to 18 % interest rates for hard money lenders.
Commercial real estate loans for income producing properties are typically structured in one of two ways:
- Interest rate reset; OR
- Balloon payment
With an interest rate reset, it means the loan is a variable rate loan. You have an initial interest rate for the first 1-5 years, at which point the rate can increase or decrease based on what the market is like at that time. To estimate monthly payments on a loan with a rate reset, try our Commercial Real Estate Loan Calculator.
The other popular type of commercial real estate loan is a balloon loan. With this type of loan, you’ll typically have a 5-10 year term, but the loan is amortized over a longer period of time. For example, suppose you get a 7-year $500,000 loan at a 6 % interest rate amortized over 30 years. You will pay $1,472 every month for 7 years. At the end of the 7th year, you will still owe $406,352. You will either have to pay this balance all at once in a single balloon payment or refinance it with another loan (either from the same lender or a different lender). If you refinance, keep in mind that you may end up paying a higher interest rate based on the state of the market at the end of your term. Use this Balloon Loan Calculator to estimate monthly payments on a balloon loan.
You may be responsible for certain fees when you apply for commercial real estate loans. Some things to look out for:
- Application and Packaging Fees
- Appraisal and Survey Fees
- Environmental Studies
- Prepayment Penalties
Application and packaging fees are an initial fee that may be charged for the bank to even consider your request for a loan. They can range from $500 to as much as $12,000 or more! Complex deals involving institutional owners and large deals will carry larger fees.
The cost covers such things as obtaining credit reports and the lender’s time in finding public record data about your business. How do you know if it’s a legitimate fee? If you’re dealing with an FDIC-insured bank, you probably don’t have to worry. If you’re dealing with an independent broker, be careful.
Appraisals, Surveys and Environmental Studies
Appraisals, surveys, and environmental studies can also amount to a pretty large chunk of change. The lender will hire a licensed appraiser to assess the value of the property. The fees will vary according to the size and type of the property you’re buying, but appraisals average $2,000-$3,000.
Surveyors measure the boundaries of your parcel of land and charge about $300-400 (more for larger properties). Environmental studies, which are mandated by the EPA, are designed to study the impact of your real estate purchase on the local environment, considering everything from air quality to endangered species. Costs typically range from $300-$2,000, but can go significantly higher depending on the size and type of the property.
Be wary of prepayment penalties, which are unfortunately common with commercial estate loans because of their large dollar amounts. According to Metropolitan Capital Advisors, a real estate investment firm, “a typical structure may be a 5-year term loan with prepayment locked out the first two years, followed by a 3 %, 2 %, and 1 % prepayment penalty in each of the following years.” This means you cannot prepay the loan for the first two years. After that, there’s a fee which declines steadily each year. Your prepayment penalty may be structured differently. Make sure you are aware of any prepayment penalties before signing a loan agreement.
How to Apply – Putting Together Your Loan Application
Once you and your property meet the minimum requirements to qualify for a loan, you will be ready to submit your loan application. Different lenders will require different documents for loan application. At minimum, you will need the following: Personal and Business Financial Statements, Resume, Real Estate Proforma, and Rent Rolls (if applicable).
Personal and Business Financial Statements:
Banks generally require all principals, partners, and guarantors of the business to provide personal financial statements and personal tax returns for the last 2 years as part of the loan application. A personal financial statement will list an individual’s assets and liabilities. Assets include things like savings and checking accounts and stocks. Liabilities includes things like personal credit card debt, mortgage, car loans, etc.
Business financial statements and business tax returns, if available for the property, must also be submitted.
Highlight commercial real estate or business industry experience in your resume. Include resumes for yourself and your entire management team and highlight relevant qualifications. For instance, if you’re acquiring a hotel property, and your VP has years of hospitality experience, make sure to mention that.
Real Estate Pro Forma:
A real estate pro forma is basically another word for income and expense projections. You should provide at least 3-5 years of projections.
The pro forma for an income producing property must account for vacancies. The property won’t be filled to capacity throughout the year, and your projections should reflect this fact. Since actual vacancy rates are hard to predict, a fixed percentage of vacancies is usually assumed. You also need to forecast things like lease renewals, leasing commissions, and tenant improvements.
Click here for step-by-step instructions for creating a real estate pro forma and to see a sample.
You must include rent rolls. Rent rolls show the rent each tenant is paying, when each tenant’s lease expires, and other information about each tenant. Here’s a sample rent roll.
Finding a Non-Bank Lender
Equity and Mezzanine Financing
Usually, equity financing is stacked on top of a loan for the purchase of commercial real estate. For instance, a borrower might obtain a bank loan with an 80 % LTV ratio, obtain 10-15 % LTV through equity financing, and self-finance the rest. However, you must be careful about using equity financing because there are often restrictions in loan agreements on ownership changes in the property. If ownership changes hands, the lender could declare you in default of the loan.
Investors can include your family and friends and real estate investment firms. Attending meetings of you local chapter of the National Real Estate Investors Association can also connect you with investors. You can even find investors through special real estate crowdfunding websites like RealtyShares. With equity financing, you have to sell some shares in your property to the investor, so you are losing some ownership.
Mezzanine financing is a type of financing where the investor takes a junior lien on the property and can take over the property if the management team violates a covenant of the loan agreement. For example, if you promise to hold your property at 75 % capacity and you lose half your tenants, the mezzanine financier can come in and take over the property from you.
The Bottom Line on Commercial Real Estate Loans
Commercial real estate loans can seem intimidating and difficult to obtain. However, as long as you have a clear plan for running the property successfully, most lenders are willing to give you a loan. Of course, selecting a property with good tenants and in an economically sound area doesn’t hurt either!
If you have an income producing property in your sights and are ready to find out if you qualify for commercial real estate financing, visit South End Capital.
If your business will be operating out of the building, and using at least half the space, speak with a commercial real estate loan expert from SmartBiz.