Unlike residential loans, which are primarily designed for individuals purchasing a home to live in, commercial loans cater to real estate investors looking to purchase income producing properties. This guide dives deep into the nuances of commercial loans.
Commercial loans are typically offered by local banks and are tailored for investment properties rather than personal residences. This distinction is crucial, as the terms, interest rates, and qualification criteria for commercial loans are aligned with the profitability and risk of the property being purchased, rather than the borrower's personal income or credit alone.
When applying for a commercial loan, banks look at two main aspects: the borrower's qualifications and the property's financial performance.
The bank will likely want to see:
The bank will also scrutinize the property you wish to purchase. Key factors include:
Understanding and calculating the DSCR is vital for securing a commercial loan. The formula is straightforward:
DSCR=Net Operating Income (NOI) / Debt Service Yearly
For instance, if an apartment generates $10,000 monthly income and has $4,000 in monthly expenses it has an NOI of $6,000. To calculate a DSCR of 1.2 on this property the calculation is:
$6,000/1.2 = $5,000/month or $60,000/year
Said another way, this property's income can support a monthly loan payment of $5,000.
The DSCR indicates that after paying all expenses, the property still has a buffer to cover unforeseen expenses or vacancy and still meet its debt obligations.
Commercial lenders typically require a down payment of at least 25% of the property's purchase price. This equity investment by the borrower reduces the lender's risk. If the property's DSCR does not meet the lender’s criteria, they may ask for a larger down payment to ensure the loan is adequately secured.
Interest rates on commercial loans can vary, but as of the time of writing in 2024, you might expect rates around 7.25% with a 25-year amortization period. These loans often have a fixed rate for the first five years, with the possibility of interest-only payments during the first year, which can be beneficial if you plan to renovate or improve the property's income potential. After 5 years the rate will either balloon (full payment due) or the rate will reset to current rates. So payments can go either down or up at that 5 year reset.
Commercial real estate lending is heavily relationship-based. Unlike residential loans that are often sold off to secondary markets, commercial loans are usually kept on the lender’s books. As a result, banks are more invested in the borrower’s long-term success.
Establishing a strong relationship with your local commercial lender is crucial. This relationship can:
Some banks might require you to maintain a deposit account with them or keep reserves as part of their agreement to lend. It’s essential to discuss these terms upfront and understand the bank’s requirements.
Not all commercial lenders are the same. Some may specialize in specific property types or geographic areas, while others may have different appetites for risk. Working with a real estate professional or connecting with other investors can help you identify the right lender for your needs.
While both loan types involve securing real estate, commercial loans differ in several ways:
What is the minimum DSCR required for a commercial loan?
Lenders typically require a DSCR of at least 1.2 to 1.25, ensuring that the property generates sufficient income to cover both expenses and debt payments.
How much down payment is required for a commercial real estate loan?
A down payment of at least 25% is usually required for commercial real estate loans. Some lenders may go down to 20% on a case by case basis.
Are commercial loan interest rates higher than residential loan rates?
Yes, rates are usually 100-150 basis points higher than residential loan rates and they are on shorter amortization schedules. Residential loans are usually on a 30 year amortization schedule while commercial loans are on 20-25 year amortization schedules.
Can I get a commercial loan for a property in a high-crime area?
It depends on the lender's risk appetite. Some banks may avoid lending in high-crime areas, while others may be open to it.
How does relationship banking benefit real estate investors?
Relationship banking can offer better loan terms, flexibility, and a smoother loan process, especially for repeat borrowers.
What happens if my DSCR is below 1.2?
If your DSCR is below 1.2, the lender may ask for a larger down payment to get you to the 1.2 DSCR.
Do commercial lenders have high origination fees?
Commonly they charge a quarter point to a full point paid by the borrower at closing. One point is just 1% of the loan amount paid as a fee.
Do commercial lenders charge a prepayment penalty?
Commonly on a refi they do and on a sale they do not. If your loan is fixed for five years a common prepayment would be 3,3,2,2,1. Which means if you paid off the loan in year 3 you would owe 3 points on the loan balance.
Securing a commercial loan for real estate investment is a nuanced process that goes beyond merely comparing interest rates. Understanding the qualification criteria, the importance of DSCR, and the value of relationship banking are all critical components in successfully financing your real estate investments. By working closely with local commercial lenders and focusing on the financial health of the property, you can navigate the complexities of commercial loans and start to use them as a powerful tool to acquire properties.
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