Loan Advisory

Understanding Commercial Mortgages

What is a Commercial Mortgage?

A commercial mortgage is a loan secured by business property, used to purchase, develop, renovate, or refinance commercial real estate, such as office buildings, retail stores, industrial facilities, apartment complexes, hotels, and shopping centers. Unlike residential mortgages, which finance primary residences or vacation homes, commercial loans are specifically designed for business property ownership and operations.

Why Businesses Use Them

Securing a commercial mortgage can help businesses save money on rising rental expenses, reduce overall cost structures, and provide financial flexibility, especially during challenging economic times. Companies use them to buy property, develop or renovate owner-occupied businesses, obtain land development investments, and acquire buy-to-let premises to lease out.

Key Differences from Residential Loans

Commercial mortgages generally have stricter underwriting processes, higher closing costs, and typically higher interest rates compared to residential loans. They often require a larger down payment, usually between 20% and 30%, but sometimes up to 50%. The processing time is also generally longer, often taking around 3 months, and up to 6 months for construction loans.

Types of Commercial Real Estate Loans

The type of commercial loan right for you depends on your business strategy, property type, and credit availability. Common types include:

Conventional Commercial Mortgages

Provided by banks and credit unions, these are used for owner-occupied and investment properties. They often require a personal guarantee and a review of global cash flow, as well as personal and business income tax returns. Rates are typically lower for "permanent loans" on developed, well-rented properties.

Conduit or CMBS Loans

These loans are packaged together and sold to investors as Commercial Mortgage-Backed Securities (CMBS). Issued by investment banks, they often have fixed interest rates, a balloon payment at the end of the term, and may allow interest-only payments. CMBS loans often include strict prepayment penalties like yield maintenance or defeasance.

Agency Loans (Fannie Mae & Freddie Mac)

Offered via approved lenders and backed by government-sponsored enterprises (GSEs), these loans primarily target multifamily and affordable housing properties. They can offer favorable rates, fixed interest, and lower down payments (as low as 10% for some programs). Fannie Mae and Freddie Mac are major sources of apartment building loans.

SBA Loans (7(a) and 504)

Guaranteed by the Small Business Administration (SBA), these loans help businesses secure financing through partner lenders.

SBA 7(a) Loans: Used for developing owner-occupied property where the business occupies over 50%, or for purposes like business expansion, acquisition, inventory, equipment, renovation, or refinancing non-property debt. They can be fixed or variable rate, fully amortize up to 25 years, and the maximum rate depends on the prime rate.
SBA 504 Loans: Geared towards borrowers utilizing over 50% of their property, structured with two loans – one from a Certified Development Company (CDC) (40%) and one from a bank (50%). Used for investing in equipment, building or upgrading facilities, purchasing land or buildings, developing land, or refinancing debt tied to expansion. They are fully amortized with terms up to 20 years and allow for larger financing amounts than 7(a).

Bridge Loans

Short-term financing (typically 6 months to 3 years) used to "bridge" a gap until permanent financing or a property sale. They have higher interest rates than traditional loans but offer quick funding. They are often interest-only. Select Commercial offers bridge loans for borrowers facing short-term obstacles.

Hard Money Loans

Provided by private investors for situations like fix-and-flip projects, distressed assets, or borrowers with poor credit history. Terms are short (1-3 years), interest rates are high (10%+), and approval is heavily based on property value rather than solely creditworthiness, secured by sufficient property equity. These carry significant risks, as lenders can seize collateral if income isn't produced. They are typically interest-only.

Construction Loans

Finance new development or major renovations, typically with terms of 1-3 years and variable interest rates. Funds are disbursed in stages based on project milestones.

Mezzanine Loans

Supplement senior debt when additional capital is needed, structured as junior debt. They have high interest rates (10-20%+) and terms of 3-10 years, sometimes including equity participation.

Preferred Equity Investments

An equity investment (not a loan) positioned between debt and common equity in the capital stack, offering preferred returns (10-15%+).

Loan Terms and Structures

Commercial loan terms and structures can vary. Key terms to understand include:

Term Length & Amortization

Commercial mortgages often have shorter terms (3, 5, 7, or 10 years) compared to residential loans, though some can extend up to 25 years, and certain large mortgages or FHA/HUD loans can have terms of 30-40 years. While the term may be short, the amortization period (the schedule for principal repayment) is often longer, commonly 20-30 years, to keep monthly payments affordable.

Balloon Payments

A common feature where a large lump sum of the remaining balance is due at the end of the loan term. For example, a 10-year term based on a 30-year amortization schedule means you pay P&I for 10 years, then owe the remaining balance as a balloon payment. Calculators can figure the balloon payment based on the amortization period. If you cannot make the balloon payment, refinancing before the term ends is recommended to avoid foreclosure.

Interest-Only Payments

Some commercial loans allow borrowers to pay only the interest for the entire term, with the full principal balance due as a balloon payment at the end. Calculators can help estimate interest-only payments. Bridge and hard money loans are typically interest-only.

Principal and Interest (P&I) Payments

This is the standard method where each payment includes both principal and interest, with the portion going to principal increasing over time. Calculators can determine P&I payments and show the amortization schedule.

Interest Rates

Commercial loan rates are influenced by property type, location, leverage, debt service coverage ratio, borrower financial strength, and relationship with the lender. Rates are typically higher than residential mortgages (0.25% to 0.75% higher). They are often tied to indexes like the Prime Rate, LIBOR (historically), U.S. Treasury Bonds (especially the 10-year note), and Swap Spreads. There is no single "master rate sheet" for commercial loans; rates are determined for each specific customer and scenario.

Recourse vs. Non-Recourse

Commercial loans can be recourse (requiring a personal guarantee) or non-recourse (lender cannot pursue personal assets if the borrower defaults). Conventional loans typically require a personal guarantee. Most non-recourse loans have stipulations that can make them full recourse if certain rules are violated.

Prepayment Penalties

Commercial loans often include penalties if the loan is paid off early. These can be step-down penalties, yield maintenance (especially for conduit/CMBS loans), or defeasance.

Qualification Requirements

Lenders conduct a thorough review to assess the risk profile of a commercial loan. Key qualifications include:

Business and Personal Credit Scores

Lenders check both to determine the appropriate interest rate, term, and down payment.

Business Credit Scores: Assessed by agencies like FICO (SBSS score, preferably 160+), Dun & Bradstreet (PAYDEX score, 80-100 preferred), and Experian (score of 80+ preferred).
Personal Credit Score: Most lenders prefer a FICO score of at least 680, with 700 being more favorable. Lenders check for recent negative events like collections or bankruptcies.

Down Payment

A significant down payment is required, typically 20% to 30%, sometimes higher. Owner-occupied businesses may qualify with as low as 10% down or even up to 90% LTV financing.

Company's Age

Lenders prefer businesses running for at least 2 years, especially with excellent credit history, though older businesses often have higher approval chances.

Occupancy Requirement

For owner-occupied businesses, lenders often require the business to occupy 51% or more of the property. If this isn't met, an investment property loan might be more appropriate.

Lending Ratios

Lenders evaluate ratios to assess risk:

Loan-to-Value (LTV) Ratio: The ratio of the loan amount to the property's appraised value. Lenders typically accept 60% to 80% LTV, depending on the property type. Higher LTV indicates higher risk and may result in a higher interest rate.
Debt Service Coverage Ratio (DSCR): Measures the company's ability to cover debt obligations using its net operating income (NOI). Calculated as NOI divided by total annual debt service. A preferred range is 1.15-1.35, with most lenders requiring 1.25 for approval.
Debt Ratio: Evaluates personal debt by dividing personal monthly debt by monthly income. While less focused on than for residential loans, lenders use global cash flow analysis (property income + borrower's income) to assess overall coverage.

Borrower Strength

Lenders assess the borrower's net worth, liquidity (often 10% of the requested loan amount after down payment), and experience with similar properties.

The Application Process

Required Documents

Be prepared for an extensive documentation process. Documents commonly required include:

Income tax returns (up to 5 years)
Third-party appraisal reports
Business and associates' credit reports
Leases
State certification
Business accounting books (up to 5 years)
A business plan

Timeline

The process typically takes around 93 days (3 months) from application to closing. Construction loans can take up to 6 months. This is significantly longer than residential loan closing times.

Closing Costs

Besides the down payment, factor in closing costs such as:

Underwriting fees ($500-$2,500)
Lender's origination points (0.25%-0.5% for banks, 2%+ for independent lenders)
Appraisal fees ($1,000-$25,000+ depending on project size)
Title insurance ($2,500-$15,000)
Property inspection fees ($0.03-$0.10 per sq ft)
Environmental report fees ($2,000-$6,000)
Broker's fees (1%-1.5% for loans up to $5M)

A third-party appraisal is commonly required, especially for federally-backed loans over $500,000. An environmental report (Phase 1) is a required step.

Getting the Best Deal

Shop Around: Contact multiple loan providers (banks, credit unions, insurance companies, government-backed lenders, private investors) as lending is subjective and comparing offers allows you to find the most favorable deal.
Consider a Commercial Mortgage Broker: Brokers can add significant value by helping you find the best rate and ensuring a smooth process.
Leverage Your Deposit Relationship: If your business has high cash flow, offering to transfer accounts to a lending bank can potentially help secure a better deal.
Understand Rate Locking: Lenders have different procedures for locking in rates (at application, commitment, or prior to closing). In a rising rate environment, it's crucial to understand when your rate is locked.
Wait for a Term Sheet: Before paying for an appraisal, request a non-binding term sheet from the lender outlining the estimated terms.
Location Matters: Local lenders may offer better deals than out-of-town lenders.

Current Market & Property Type Considerations

Market conditions, including interest rates and inflation, significantly impact CRE lending. Different property types also have varying risk profiles and lending availability. Lenders emphasize property cash flow, LTV, DSCR, and borrower strength when underwriting.

Office

Split market between demand for top-tier buildings and falling interest in older properties; lenders may be hesitant, requiring more borrower equity.

Industrial

Strong sector driven by e-commerce and supply chain needs; expected solid rent growth and low vacancies.

Retail

Rebounding due to lack of new supply and continued sales growth, despite inflation and labor shortages.

Hospitality (Hotel/Motel)

Investment activity may remain subdued due to decreasing revenues and rising costs, though leisure and business travel increases could help certain locations. Often financed with bridge or CMBS loans.

Self-Storage

Recession-resilient with high occupancy and low operating costs.

Medical Office Buildings (MOBs)

Stable tenant base with long-term leases.

Single Room Occupancy (SRO) Properties

A subset of multifamily housing, often viewed through the lens of affordable or supportive housing. Financing options are specialized and may include Fannie Mae/Freddie Mac (for stabilized properties), HUD 221(d)(4) (for construction/rehab with services), LIHTC + Debt, HUD 811 (grant-based), state/local programs, private equity, or hard money for rehab. Key underwriting considerations include occupancy stability, tenant profile, rent restrictions, building condition, location, and exit strategy.

Need Expert Guidance?

Navigating commercial real estate financing can be complex. Our team of experienced advisors is ready to help you understand your options and find the best solution for your specific needs. Contact us today to schedule a consultation.

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