Recent turmoil in the regional banking industry, coupled with rising interest rates, have made it much more difficult for borrowers to obtain loans for commercial real estate.
The collapse of Silicon Valley Bank of Santa Clara, First Republic Bank of San Francisco, and Signature Bank of New York have brought increased oversight and scrutiny to regional banks, which fund the majority of commercial real estate loans. Add that to the depreciation in value (and mounting debt) in large office properties in many primary markets, and you have a tough lending landscape for CRE investors.1
Yet it’s not impossible to get funded for a commercial real estate acquisition. Here’s how the process works.
What are Commercial Real Estate Loans?
Commercial real estate describes a wide range of income-producing properties, including high-rise office buildings in San Francisco, shopping malls in Austin, and the standalone triple-net retail buildings that dot nearly every corner of American suburbia.
Real estate investors who buy and exchange these income-producing properties often finance their acquisitions using commercial real estate loans. These loans are a bit like the loan on your home – the mortgage note for the target property is backed by a physical asset. However, the lending criteria and other characteristics of commercial real estate loans are much different than residential loans.
Residential Loans
- Loans are usually for either 15 or 30 years.
- Interest rates are fixed.
- Loans are made to individuals or married couples.
- Loan-to-value ratios at 80 percent or lower.
Commercial Loans
- Loan lengths typically range from five to 20 years.
- Loans are made to corporations, LLCs, limited partnerships, and other business entities.
- Loan-to-value ratios usually range from 65 to 80 percent.
- Interest rates vary by lender and loan length. Longer loans tend to carry higher interest rates.
Commercial loans are usually made to business entities that have been formed specifically to own commercial real estate. Separating the asset from personal holdings provides an important legal layer of financial protection for CRE investors. Commercial loans that aren’t personally guaranteed are called non-recourse loans – lenders can only seize the mortgage-backed property in the event of borrower default.
Lastly, these loans are used by Main Street CRE investors to acquire or refinance commercial properties, or by developers and builders to acquire, develop, and construct new commercial properties and residential communities.
How to Obtain a Commercial Real Estate Loan
Loan qualifications will vary by lender, but commercial lenders generally look at the same criteria when evaluating CRE loans. Qualification criteria includes:
- Creditworthiness of the borrowing business entity
- Loan-to-value ratio
- Debt-service coverage ratio (DSCR)
- Financial statements of the business entity
- Credit score above 660
Borrowers typically must have at least 25 to 30 percent equity in a property, or put up 25 percent of the total loan amount as a down payment. You’ll also have to buy insurance for the asset to protect the lender’s financial position in the property in the event of a major catastrophe.
Borrowers will have to provide both business and personal tax returns to demonstrate their financial wherewithal, and meet minimum credit requirements. Lastly, debt-service coverage ratio is a key metric used in the qualification process for commercial real estate loans. The DSCR shows lenders you have the ability to service your existing debt as well as take on any new financing.
SBA 504 Loans
Banks, credit unions, and other private lenders aren’t the only way to get financed for a commercial real estate loan. The U.S. Small Business Administration’s 504 Loan Program works with community-based third-party lenders (typically regional banks and credit unions) to provide long-term fixed-rate financing up to $5 million for qualifying businesses.
In order to meet qualifying criteria, your business must:
- Be a for-profit entity
- Have a net worth of less than $15 million
- Average less than $2 million in after-tax net income two years prior to applying for a 504 loan.
You also might have to provide a business plan, demonstrate your managerial experience, and meet other guidelines in order to qualify.2
SBA 504 loans can be used to purchase an existing piece of CRE or to finance new construction. They also can be used to modernize and upgrade existing commercial real estate properties. They can’t be used for income-generating investment properties, however.
These loans have repayment terms of 10, 20, and 25 years at below-market fixed interest rates. SBA 504 loans include a first mortgage of 50 percent of the loan total, which is funded by the third-party lender, along with a second mortgage of 40 percent that’s backed by the Small Business Administration. The borrower puts in the final 10 percent as a down payment.3
Putting it all Together
Lenders evaluate a host of factors when determining a borrower’s ability to obtain a commercial real estate loan. Each aspect of qualification criteria is but one part of an overall picture that you’ll have to paint for CRE lenders to demonstrate you have the creditworthiness and financial strength to manage new debt along with any existing financial obligations.
Qualifying for these loans can be a bit more complex than taking out a home mortgage, and recent events in the banking and financial sectors may make the qualification process even more onerous. A good starting point is to have an initial discussion about your financing needs with a regional bank or credit union in your home market, especially if you have a longstanding banking relationship with the prospective lender.
1 Commercial Real Estate Sector Faces Risks as Financial Conditions Tighten, International Monetary Fund, https://www.imf.org/en/Blogs/Articles/2022/09/21/commercial-real-estate-sector-faces-risks-as-financial-conditions-tighten
2 504 Loans, SBA.gov, https://www.sba.gov/funding-programs/loans/504-loans’
3 504 Loan Program, SBA.gov, https://www.sba.gov/brand/assets/sba/sba-lenders/504-Loan-Fact-Sheet-Borrower-Version.pdf
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
