Navigating the Commercial Loan Process
People who are new to the world of real estate investing often carry expectations based on their familiarity with residential loans and mortgages. While there are some basic similarities between the two types of loans – both have an underwriting process that moves from pre-approval to closing – commercial loans differ in some key respects.
The most important distinction lies in the function of a commercial loan. While you use a residential mortgage loan to buy your primary residence, the purpose of a commercial loan is to generate business income. You can also get a commercial loan to make improvements on a business asset or to construct a new build.
Commercial loans have a wider range of lenders, including private investors and other capital sources. There are also differences in the loan approval and repayment process.
When you buy a personal residence, the property itself will count as collateral for the loan and you, personally, become the designated borrower. The commercial loan process takes a broader view of assets. At the same time, it has more stringent requirements.
Investors generally seek commercial loans under an entity such as a corporation, LLC, or partnership. The entity – not the individual – is the borrower, and loan preapproval involves careful scrutiny of the financial history of the business and its assets.
Lenders use a loan-to-debt (LTD) ratio to determine whether there is enough value in the property to guarantee the loan. The amount of the mortgage is divided by the sum of the entity’s net income and the appraisal value of the property. The LTD can be no higher than 75 percent for a non-recourse loan.
If you don’t have an established financial track record for the business, the lender may offer a recourse loan, using your personal assets as collateral. This means that if you default on the commercial loan, the lender has the option to seize those assets in order to recover any deficiencies between the foreclosure proceeds and the loan value.
Another thing that lenders scrutinize carefully during the commercial loan process is whether your business has enough positive cash flow to make it a good risk. Lenders prefer to see steady net income that is at least 20 percent higher than any debt the business carries. You will be asked to show some or all of the following:
• Tax documents for the last three years, including schedules.
• Financial statements.
• Evidence of assets that can readily convert into cash.
• Documentation of the proceeds from leases and rental income.
Lenders calculate the amount of positive (or negative) cash flow available by using the debt service recovery ratio (DSCR), or the relationship between a property’s annual net operating income (NOI) to the loan’s principal and interest payments.
Residential loans use an amortized schedule with regular monthly installments over a set term, usually 30 years. You pay the same amount each month, but over time you pay less interest and more principal until the loan is completely paid off.
By contrast, commercial loans are shorter in duration, ranging from five to 20 years on average. Moreover, the amortization period of a commercial loan may outlast the scheduled repayment period, leaving an outstanding sum, or a “balloon,” to be repaid at the end.
For example, a loan may have a term of five years but an amortization schedule that lasts 15 years. Commercial borrowers pay the lion’s share of interest, presumably while they are using the proceeds of the loan to invest in their business. They then pay back the bulk of the principal when the loan term ends.
Unlike most residential loans, which have no prepayment penalty, commercial loans make it harder for the borrower to repay the loan before its maturity date by imposing a penalty that preserves some of the lender’s anticipated profit from the loan.
The penalty can take several forms, including
• a basic prepayment penalty, which multiplies the outstanding loan balance at the time of payment by a standard percentage.
• an interest guarantee, which entitles the lender to a specific rate of interest for a set period of time in addition to an exit fee when the payoff occurs.
• a lockout, which stipulates that the lender cannot pay off the loan before a certain number of months or years.
Overall, commercial loans involve a complex and reciprocal relationship between borrower and lender, one that is entered into only after careful scrutiny. Both sides make an investment that they hope will pay off. Meanwhile, each side seeks to protect their interests and maximize their yield.
About Peak Finance Company, Commercial
Peak Commercial provides unparalleled access to conventional debt financing, joint venture equity, mezzanine and bridge financing, and structured debt to make the commercial loan process more intuitive. They are able to secure the best terms available in the marketplace for clients across a broad spectrum, including Wall Street investment banks, pension and opportunity funds, commercial banks, insurance companies, and private equity investors. Their professionals can help you find the right financing for your commercial real estate needs.