How to Get A Real Estate Loan for Your Business
As a small business owner, finding a great piece of commercial real estate can be an exciting opportunity for your business. Moving into a new location, adding new facilities to your business, or even purchasing your first piece of property as a business can mean bigger and better things for your company.
In this article, we’ll address some of the popular options for funding your commercial real estate along their typical qualification requirements. Through this, hopefully you will be able to get an idea as to which loan program, might be right for you and your business.
What is a Commercial Real Estate Loan?
Most small business owners must apply for a real estate loan in order to make a real estate purchase. These loans allow small businesses to access capital that is specifically intended for purchasing real estate. One of the benefits of these loans is that they typically do not require collateral or a personal guarantee. This is because the commercial property your business is purchasing serves as the collateral.
As a note of caution, if you are planning on applying for a commercial real estate loan, you should make sure that your business is structured as a limited liability company (LLC), limited partnership (LP), S corporation, or C corporation. If you are operating a sole proprietorship, then you would have to apply for a personal real estate loan rather than a commercial real estate loan. If you decide to do this, you should proceed with the utmost caution, as this would jeopardize your personal finances should you be forced to default on the loan.
Properties that commercial real estate loans can be used for include office buildings, industrial buildings, warehouses, shipping centers, storefronts, retail centers, and more. They can essentially be used for any real estate that will be used for conducting business 51% or more of the time.
Remember, before purchasing any property, you should have it appraised and inspected by a third parties not associated with the sale. Real estate agents can sometimes give a good estimate, but they are typically trying to sell you the property. As with any large purchase, it is always good to have an unbiased opinion.
What Qualifications Are Lenders Looking For?
As with any loan, commercial real estate loans require that you meet certain qualifications. This is the way lenders assess the risk they are taking on by providing you with a business loan. These qualifications typically involve your business’s finances, your personal finances, and the different aspects and characteristics of the property itself. They will check these different aspects of your finances as part of the application process. As always, the more financially sound each of these components is, the more favorable the corresponding loan will be.
Obviously, the most important qualifications you will need to meet pertain to your business’ finances. Before applying, you’ll want to have your business’s paperwork organized and on hand. This means having orderly and neat books, revenue and profit projections for the next year, relevant financial statements, and a business plan. Having these organized ahead of time will not only make the loan process easier, but can also make the process faster, which can be extremely beneficial for businesses looking to move into the new property as soon as possible. The lender will take particular interest in your business’s cash flow, as this will help the bank determine whether or not your business will be able to meet the loan’s monthly payments.
For brick-and-mortar banks in particular, since you will almost certainly have to meet with a bank representative, you will want to have a clear picture of your plans for the business, what you expect for the future, and, most importantly, how this new piece of property will fit into the equation.
Before applying for a commercial real estate loan, check your business credit score. Scores will vary based on the agency calculating it, but as a general reference, a business’s credit score should typically be in the following range for these agencies:
- A Dun & Bradstreet Paydex score should be 80 or higher on a scale of 0 to 100
- An Experian Intelliscore should be 80 or higher on a scale of 0 to 100
- An Equifax Business Payment score should be 90 or higher on a scale of 0 to 100
- A FICO Liquid Credit Small Business score should be 160 or higher on a scale of 0 to 300
Remember, your business credit score will play a large role in determining your financing options with regard to the interest rate, repayment term, and required down payment. The better your business credit score is, the more favorable the loan options and loan terms and will be. This is particularly important for the interest rate, since you will obviously want to obtain the lowest interest rate possible.
Banks may also want to check your personal finances before providing your small business with a loan, particularly if your business’s finances and business credit score are sub par or just barely meet the required threshold.
Banks will check your personal credit score to get an understanding of your personal financial standing. They’ll want to know of any loan default or outstanding debts you have. Obviously, the better your personal credit score is, the better chance your business will have of being approved. As with your business’s credit score, the higher your personal credit score, is the more favorable the loan terms will typically be.
Banks may also request to see personal financial statements and tax returns as part of assessing your overall net worth and cash flow. However, since you will be taking on a commercial real estate loan, your personal finances should be protected since the property will serve as the loan collateral. As always, you should have a qualified lawyer inspect the terms of any bank loan before you sign the dotted line. This way, you’ll be able to know exactly what you are liable for.
Property Traits and Characteristics
The traits and characteristics of the property you are looking to purchase will also impact the terms of the loan and whether or not you qualify. Obviously, in order to get a commercial real estate loan, the property must be intended for commercial use. Further, not only must it be a commercial property, but it also must be intended for your business. This means you business should be using and/or occupying the space more than half of the time it is being used.
What Exactly Should I Prepare Before Applying for a Loan?
Each financial institution may have its own requirements, but it will help speed along the application process if you have the following readily available:
- Business books and financial records
- Current and projected cash flows for a number of years out
- A business plan that details your plans and expectations for the future and includes how this property acquisition fits into your agenda
- Your business’s credit report
- Your personal credit report (for yourself and any other business owners)
- Copies of your business’s formation paperwork (For example, if you operate an LLC, you should have a copy of the paperwork verifying your LLC’s registration with the state.)
What is a Loan-to-Value Ratio (LTV)?
The loan-to-value ratio (LTV) is an integral part of commercial real estate loans. It determines the down payment your business will need to be able to pay prior to acquiring a loan for the property. The loan-to-value ratio is simply the value of the loan in relation to the value of the property. As an example, the loan-to-value ratio on a $80,000 loan for a $100,000 property would be 80% (80,000 / 100,000 = 0.8, which is the same as 80%). The LTV is the value of the loan divided by the value of the property, multiplied by 100.
LTVs for commercial real estate loans typically range from 60% to 80%. It is rare to find loans programs with a higher offering. An important thing to remember is that the higher the LTV, the higher the interest rate will typically be. Lower LTVs typically come with more favorable loan terms and better interest rates because your business has more equity in the property to begin with. This means lenders view lower LTV loans as less of a risk.
What is a Debt-Service Coverage Ratio (DSCR)?
Potential lenders will also consider your business’s debt-service coverage ratio (DSCR). The DSCR is used to assess your business’ ability to service its debt. It takes the net operating income (NOI) of your business at the specific property you are interested in, which is based on your business’s history and projections, and compares that to the annual mortgage of the property.
It is calculated by the following: net operating income (NOI) / annual mortgage debt service.
For example, let’s say your business does $200,000 in net operating income each year. The the annual mortgage debt your business will need to service on the property is $100,000. If this is the case, your DSCR would be 2.0. This would be a very good DSCR.
On average, lenders will look for a DSCR ratio of at least 1.2 to ensure your business has adequate cash flow to cover its debts. A DSCR of less than 1.0 would mean your business will be unable to service its debt.
What Types of Prepayment Penalties Should You Know About?
Prepayment penalties are contractual obligations assigned to the borrower in order to protect the lender from a business’s early exit from a loan. Prepayment penalties come in different forms, but, essentially, with a prepayment penalty, if your business decides to pay off the loan early, you will be responsible for it.
Interest guarantees are a form of prepayment penalties. Under an interest guarantee, the lender is guaranteed a specific amount of interest on the value of the loan even if you decide to exit early.
Lockouts are also a common protection for lenders. Lockouts are a period of time, such as five years, in which the borrower cannot pay off the loan in full and exit.
Again, make sure you consider prepayment penalties and have a qualified legal professional look over your loan contract before signing.
What Types of Commercial Real Estate Loans Are Available?
There are a number of different commercial real estate loan options on the market for small businesses. In this next section, we’ll cover some of the more popular ones.
Traditional Commercial Real Estate Loans From a Bank
The traditional, time-honored way of receiving financing for a real estate purchase is through brick-and-mortar banks. As such, many small businesses prefer to go this route. One of the great things about banks is that they typically have some of the best loan programs. This means longer terms, flexible LTVs, and, best of all, some of the best interest rates on the market.
However, as always, there’s a catch. These great terms also make traditional bank loans some of the more difficult loans to acquire. Banks will be extremely thorough in their evaluation of your businesses and the risks that come with lending to you. They will want to see a healthy business history, good business credit ratings and often high personal credit ratings, low debt, and plenty of cash flow to pay off the monthly payments associated with the loan.
Brick-and-mortar banks will also typically require you to present your business plan and discuss how this property will fulfill certain needs for your business. They want to make sure you have a clear vision and that your company will be profitable throughout the life of the loan.
With all of this in mind, if you are operating a strong, successful business with good credit and top-notch financials, you may not need to look any further than a traditional commercial real estate loan. Remember to shop around though: Assess the offerings and loan programs at numerous banks. You want to find the best loan terms for your business!
Small Business Administration Commercial Real Estate Loans
There are two different loan programs the United States Small Business Administration offers businesses: the SBA 7(a) loan and the SBA 504 loan.
SBA 7(a) Loan for Commercial Real Estate
The SBA 7(a) loan is the U.S. Small Business Administration’s flagship loan. Under this SBA loan program, the government backs loans to small businesses to make lenders less apprehensive about providing loans to businesses that carry risks (meaning, small businesses).
These loans are not just limited to commercial real estate, so they can be used for myriad business initiatives. Businesses using this program can borrow up to $5 million from an SBA-affilated lender.
SBA 7(a) loans typically carry favorable interest rates, since under this program, the government limits the top interest rates that affiliates can offer. The loans are also fully amortized, meaning each payment will be the same each month and at the end of the term of the loan the property will be paid off in full.
SBA 504 Loan
The SBA 504 Loan is a loan program specifically intended for use as a commercial real estate loan. Under this loan program, businesses receive two different loans for their property.
The first loan, for 40% of the property value, will be provided by a Certified Development Company (CDC). Certified Development Companies (CDCs) are non-profits that provide small business with low interest loans, the goal of which is to promote economic development in communities throughout the United States. These non-profit organizations are certified and regulated by the SBA.
The second loan, for 50% of the property value, will be provided by a bank. These interest rates vary and are higher than the rates offered by the CDCs.
Your business will be required to post the remaining 10% as a down payment on the property.
The benefits of the SBA 504 loan program are threefold: the low interest rates (particularly those offered by the CDCs), the 20 year terms, and (like the SBA 7(a) program) the full amortization.
Commercial Bridge Loans
A commercial bridge loan is funding that a small business can access as a short-term solution for financing until longer term financing can be acquired. Bridge loans are, as the name implies, essentially a bridge between funding terms, and thus typically have a maximum term of 2 years, with a minimum of 6 months usually required.
Something to be aware of is that many bridge loans are not amortized, meaning you will only be responsible for paying the interest each month. Under the terms of these interest-only loans, once the loan expires, you will be responsible for a large balloon payment.
So, why would you acquire a bridge loan? Bridge loans are most commonly used by businesses when they find a real estate opportunity that they would really like to capitalize on. When businesses want to make sure they get the property before anyone else, they apply for bridge loans because the process is faster. Once they have the short term financing secured, they then have time to search for a favorable loan program. Once they find one, they can refinance their bridge loan with a long term funding option.
One of the benefits of bridge loans is that, unlike traditional commercial real estate loans, they typically do not require a very large down payment. They can buy businesses valuable time to come up with more funding for the down payment that will be required once they refinance with a traditional loan.
Hard Money Loans
Hard money loans are a common route for businesses with lower credit ratings that are struggling to obtain a traditional commercial real estate loan. They are also a common route for new businesses without an established history of success to show a bank.
These loans are provided by investors and private lenders instead of banks, and they typically have much shorter terms and higher interest rates. They also typically do not allow for large loan amounts. This makes them similar to bridge loans; however, their terms are almost never as favorable as those of traditional bridge loans. Your business will also be required to meet a down payment of 25% to 35%.
The loans themselves are based on the idea that the property will serve as collateral, so lenders do not have to worry as much about the credentials of the borrower. However, again, they do have higher interest rates.
Hard money loans can often be acquired rather quickly. They are not designed for longer term funding.
Because hard money loans are provided by investors or investment companies rather than banks, you’ll need to look for them online and in your local area. As always, be sure you have a qualified third-party professional look over any contract you plan on signing.
Soft Money Loans
Soft money loans are not the direct opposite of hard money loans. They are a funding category often mentioned by hard money lenders.
Soft money loans can be classified as traditional loans with below-market interest rate. Generally, qualifying for a soft money loan involves a greater emphasis on the borrower’s creditworthiness. This extra emphasis allows for more precise risk assessment.
To qualify, your business may need to prove it is able to make the first few months’ payments. They do require collateral, which — when using the loan for commercial real estate — would be the property itself. Using property as collateral is a relatively standard feature for real estate loans.
For soft money loans, LTV ratios can be as high as 70%, which requires a significant down payment, as does any loan with a low interest rate. (The higher your down payment, the less risk for the lender, and the better the interest rate they can offer you.)
Any number of different financial institutions offer soft money loans. As always, if you’re going to pursue this route, survey the internet as well as local options before choosing the one that is best for you.
Finding a great commercial real estate property can be a stellar opportunity for your business to expand and grow. In understanding the loan options available, you can make sure that the next time you see a prime piece of real estate, your business can capitalize on the opportunity.
But before purchasing any property, make sure you thoroughly consider your choice. Purchasing commercial real estate is a big decision, and with loan terms of 20 to 25 years, it can be something your business will be dealing with for many years to come. You should ask yourself questions like:
- Will this really help my business?
- What new clients will I be reaching in this new location?
- How will this impact my business’ bottom line?
Don’t forget to keep neat books and financial statements throughout the life of your business. You’ll need them not just for commercial real estate loans but all sorts of financial opportunities. The better understanding you have of each facet of your business, the better prepared you’ll be to apply for a loan.
As always, remember to be cautious whenever considering a loan. You should always have qualified third party professionals, such as a lawyer, look over the contract so that you know exactly what your business is agreeing to.
Further, don’t forget to shop around. Finding the right terms could mean the difference between success and failure for your business.