An Overview of Commercial Property Financing from Banks

Commercial property loans empower businesses with funds to purchase and renovate properties or refinance loans they already have. Traditional lenders issue these types of loans for commercial properties that generate income. These include office buildings, retail outlets, hotels, and multifamily apartments. Of note, lenders only give commercial property loans to registered business entities such as limited liability companies and partnerships.

Lenders can issue different types of commercial property loans. They include SBA-backed loans and conventional bank loans. The former are loans backed by the U.S. Small Business Administration (SBA). They include SBA 7A and SBA 504 loans. SBA 7A loans are the most popular of the two. Single commercial lenders issue them. Investors prefer them for investing in small commercial property projects. They are flexible, and the SBA guarantees up to 85 percent of the loan amount.

SBA 504 loans are better for larger projects (typically valued at over $1 million). They are issued by two entities: a private commercial lender and a certified development company. The former issues 50 percent of the project cost and the latter 40 percent. The SBA guarantees both sums so the borrower only has to put up a 10 percent down payment, though it may be more in certain instances. Lenders favor SBA-backed loans because of the government guarantee, so these usually carry lower interest rates than conventional bank loans.

Conventional bank loans are more complex. First, lenders prefer giving these loans to entities that meet certain qualifications. For example, some lenders require entities to have been in business for a minimum number of years or generate a certain annual revenue. Other requirements are a strong credit history and collateral.

Usually, with commercial property loans, the property being purchased or renovated acts as collateral. That means if the borrower fails to pay the mortgage, the lender will sell the property to recover their funds. In some cases, banks issue recourse loans where the owners or principals of the borrower entity agree to personally guarantee the loan. In such cases, if the borrower fails to pay the mortgage and the property itself does not fully cover the loan amount, the principals or owners will personally make up the difference.

The terms of commercial property loans differ from residential property loans. For example, while residential loans have payment periods lasting up to 30 years, commercial property loans typically last five to 20 years. In addition, commercial property loans have higher interest rates of up to 11 percent. SBA-backed loans have lower rates, with those for SBA 7A loans ranging from 5.5 to 6.75 percent and those for SBA 504 loans ranging from 3.5 to 6 percent.

In determining whether they will issue a commercial property loan, lenders use certain calculations including loan-to-value ratio (LTV) and debt-to-service coverage ratio (DSCR). For LTV, lenders divide the loan amount by the value of the property. The lower the ratio, the more equity the borrower has and the lower the lender’s risk. Lenders prefer this scenario over a high LTV.

For DSCR, lenders divide the net operating income a commercial property will generate by its mortgage debt service. DSCR has to be higher than 1, meaning the property generates enough income to cover its mortgage payments. The higher it is the better. A DSCR below 1 means the property’s income cannot cover its debt payments.

There are many benefits of opting for commercial property loans over other financing options like hard money loans. They include flexible payment terms and tax breaks. There are drawbacks, however. These can include long approval times, up to 20 percent down payment requirements, and fees such as appraisal, origination, and loan application fees. Even SBA loans have a guaranty fee, up to 3.75 percent of the guaranteed loan.