Understanding Commercial Real Estate Loans and Finance

  • Author: Akhila Masapogu
  • 5 min read
  • November 5, 2020
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The Commercial Retail Estate industry often works and depends on Loans and Finance options for acquiring, developing, maintaining, or constructing a commercial property. It is a debt-based contract in which CRE borrowers use these funds for non-residential properties. Commercial Real Estate Loans are different from Commercial Loans. The former category of loan is the one that CRE stakeholders look forward to and look for the best lending institutions. The latter category primarily deals in loans used for purchasing equipment or operating basic expenses.

What is Commercial Real Estate Loan?

A commercial real estate investment loan is essentially a contract between a commercial real estate property owner and a lender which has to be paid back over a specified period.

Acquiring a loan on a commercial property like office buildings, schools, retail outlets, etc., is different from a loan on a home. A residential loan involves mortgaging of a residential property that shall be made in the name of the homeowner, while in case of a CRE loan, the loan belongs to the property itself which serves as an entity. It can either be named on a single person or the entity as a whole because a commercial property does not function based on one person alone. 

Here, the phenomenon of ‘Individual or Entity’ prevails where the decision has to be made whether a CRE loan should include the single person or the entity. Both sides have their pros and cons.

Individual vs. Entity in A Commercial Real Estate Loan

This is the major point of difference between a residential loan and a loan on a commercial property. As a commercial property is solely used for purposes like business, corporate, and industrial, the property behaves like an entity. So, the investor has to decide to choose between naming the loan on the individual or the entity.

Every business loan requires the applicant’s credit score during the loan application process and this might pose as a problem in cases the loan is named as per entity as the entity has no credit score to show as its own. This further leads to showcasing the credit score of the owner as per the demand of the lender.

Based on this facet, CRE investment loan can be of two types:

Recourse Loan-

This type of loan involves the accountability of the owner in events where there is no repayment of the loan. It means the lender will hold the owner liable for repayment if the property fails to generate the capital.

Non-Recourse Loan-

This type of loan is where the lender only considers the entity. i.e. the commercial property as the only source of loan repayment without any liability from the owner’s end. The lender doesn’t have any form of debt on the property owner.

Types Of Commercial Real Estate Loans 

The market offers a variety of CRE investment loans, catering to the different aspects of investor’s needs and requirements. The CRE loans differ in their credit requirements, down payments, and eligibility criteria. 

Small Business Administration Loans-

This type of loan is provided for small businesses on the commercial property as a mortgage.

Certified Development Company Loan-

Another type of loan oriented towards small businesses. This financing is aimed at strengthening the capital growth of small businesses and provides them with a financing protocol of fixed-rate loan lending.

Traditional CRE loans-

The initial and standard method of loan is from the bank. Investors can request a loan for their CRE property as a mortgage. These are the most popular types of CRE loans that are utilized by the owner of properties like offices, retail, shopping complexes, etc.

Commercial Bridge Loan-

This type of loan broadly functions as transient financing to an investor until a long-term loan comes up. This type is beneficial for a first-time investor as a means of starting in the CRE investing sector.

Hard money loan-

As the name suggests, this type of loan is given in the form of a cumulative high-interest sum for a short period which is typically loaned by semi-institutionalized private authorities.

Conduit Loans-

This type of loan involves mortgage at the first position over a commercial property. These loans come with a fixed interest rate for over 25-30 years. One disadvantage of such type is that they inculcate a balloon payment at the end of the loan term.

Features of Commercial Real Estate Loan

Despite being a popular choice of capital source among investors, some facets of CRE loans are still hidden from the common eye. The salient features of CRE investing finance are-

  • Commercial Real Estate loans function as a medium of buying or leasing a new commercial real estate property.
  • A CRE loan can also include certain benefits such as the cost of renovations, alterations, improvements, or construction in the commercial property.
  • A CRE loan can also be availed for extensions or transfers associated with the commercial property.
  • Nowadays, lending institutions like banks also offer an added benefit of professional advising to help the investor make a profitable CRE property purchase or leasing.
  • The loan process is convenient and hassle-free.
  • The loan repayment schedule is fixed at regular intervals and is adjustable according to the loan tenure of the investor.

Things To Consider Before Applying For A CRE Loan

Although the application process of a CRE loan is easy, many investors still fail to qualify for loans. One of the key reasons behind this may lie in the application process itself. Many investors fail to recognize the crucial differences between applying for a loan on residential property and commercial property. Some may assume them to be the same procedures and this leads to making mistakes during loan applications. So, an investor looking to apply for a loan on a CRE property must keep the following points in mind-

Aim of Loan-

Most of the residential properties are purchased for personal reasons like assets or residence whereas commercial property is purchased solely for business purposes and business investments. Thus, there will be a difference of nominees in the loan of residential property and commercial property. The nominee for a residential property loan is the individual itself while in the case of a CRE property loan, the nominee for loan repayment can either be the owner or the entity (property).

Loan Contract-

Similar to the nominee, mortgages under the residential property loan are different from those under a CRE loan. The mortgages under a CRE loan are quite often not supported by government agencies unlike those in a residential loan. Additionally, there is a vast difference between the contract regulations of a CRE loan as opposed to a residential loan. The investor has to deal with stricter guidelines under a CRE loan contract due to their longer loan tenures and higher interest rates.

Value Of Property-

The value of a CRE property plays a pivotal role under the loan approval process as this will be responsible for estimating the loan-to-value ratio. A loan-to-value ratio indicates the amount which can be guaranteed as a loan according to the given property value. This is not the case in residential property loans and hence, should be considered before planning a CRE investment.

DSCR-

It refers to the Debt Service Coverage Ratio which is the ratio of the net annual income of a CRE property to the debt or expenses it has incurred over a specified period. The DSCR is an important determinant of a property’s cash flow. The lender investigates the cash flow of a CRE property because it gives an idea about the property’s profitability and future performance. A property with negative cash flow is not considered desirable for loan approval as it shows a riskier loan repayment status. A lower debt service coverage ratio can be desirable when the loan amortization period is short. This comparison is of little importance in a residential loan. 

CRE vs. Residential Loan Interest Rates-

CRE loans have a higher interest rate than residential loans owing to longer property leases and higher returns. Unlike residential loans, there are some added costs associated with CRE loans like costs of application of loan and its rejection or approval, appraisal cost, documentation costs, survey charges, and legal fees. Hence, an investor should plan the expenses ahead of a loan application.

CRE Loan Prepayment-

Another unique aspect of a CRE investing loan is the involvement of a pre-payment schedule. Unlike in residential loans, if an individual pays back the loan amount before the set deadline, he/she will face certain penalties called prepayment penalties. 

These penalties include charges like:

  • A substantial amount of money has to be paid as a penalty.
  • The individual is charged with interest rate upon early loan payment called an ‘exit fee’
  • Some lending authorities also make a provision for what is known as the loan lockout where the individual is not allowed to pay back the loan amount until the specified period is completed.
  • In case the individual wants to pay the loan amount using another property as collateral, he/she shall have to do so through the loan defeasance procedure.

The prepayment clauses of a CRE loan should be read carefully to avoid any undesired problems in the future.

Eligibility-

Several primary lending authorities come with a set of eligibility criteria which the individual has to qualify to avail of a CRE loan. The eligibility requirements of a CRE loan are much stricter than those of residential loans owing to a more professional relationship between the lender and client.

Charges Of Loan Processing-

There is also a difference in the cost of loan processing between the residential loan which amounts to about Rs.10,000 and that of CRE loans which amount to 1% of the total loan sanctioned.

Procedure to Apply for a CRE Investing Loan

The procedure for availing a CRE investment loan is hassle-free if the above-listed pointers are kept in mind before applying. The steps involved in getting a CRE loan are as follows:

  • First, decide whether the loan is to be filed as an entity or as an individual.
  • Next comes evaluations of the loan-specific attributes such as mortgages, or collaterals.
  • Enlist the type of commercial real estate investment loans available concerning the mortgage options and select the ones which are the most suitable
  • Estimate the loan-to-value/LTV ratio for the CRE property which helps decide the value of loan sanctioned
  • Estimate the DSCR for the Commercial Real Estate property which is issued for loan sanctioning.

After completion of the above procedures, the investor can apply for loan sanctioning without any worry.

Eligibility to Apply For a CRE Investing Loan

Individuals who can apply for a CRE loan include:

  • Professionals who are self-employed like Doctor, Engineer, CA, Lawyer, Architect, Consultant
  • Individuals who are self-employed like Contractor, Trader, Commission Agent

Procuring a CRE loan is a time and effort-intensive endeavor. They require proper documentation, adherence to terms and conditions, patience, and preparation, too, as the amount involved in such transactions is large. From an outsider’s point of view, the world of CRE investment financing may appear to be complex and tedious but, with thorough research, the task is indeed surmountable. CRE is a capital-rich investment, investors do need to take their time to understand different loan options available at their disposal before making the leap.

CRE Loans FAQs:

An individual can apply for a CRE property loan for purposes like:

  • CRE investment
  • For purchase of commercial property to be used as office space
  • For purchase of commercial property to be used for retail purpose
  • For commercial property leasing

No, only a conduit loan requires the protocol for a balloon payment and it is not the case of all CRE loans.

In case the investor faces a problem of the balloon payment, he/she may delegate with the lending authority into opting for a CRE loan which involves a fixed interest rate. Such type of loan is known as hybrid loans where the individual can pay the loan at fixed intervals instead of a lump sum payment at the end of the loan period.

A C&I loan refers to the loan involving a business organization instead of a single individual. It is also called as commercial and industrial loan and provide loans for requirements of machinery or work equipment in a business.

In a CRE loan, a balloon mortgage is a contract in which the mortgage of the loan does not follow amortization even after the tenure of the loan is reached. It involves the few sum payments over predetermined intervals like 5 years and on completion of this period, the total loan amount shall be paid in one go.

An amortization period in CRE loan refers to the period available for the investor for loan repayment. The investor has to pay the loan in the mentioned amortizing period otherwise he/she will face penalties. The amortization period depends on the loan down payment for example if an investor has made a down payment of 20% then the amortization period for the loan can be up to 30 years.

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