Commercial real estate can be a lucrative business for investors. When banks help fund these endeavors, it can be a great revenue stream for them as well. As with all loans, however, the lending institutions take on a fair amount of risk and evaluate applicants carefully and conservatively. If you are seeking to acquire a commercial real estate loan, you need to be aware of these three factors that inform lenders decisions about providing financing.
Dealing with Individuals vs. Entities
Firstly, it’s important to note that many commercial real estate endeavors are joint ventures between people who have formed a partnership and created a business entity, in the form of an LLC, corporation, or other appropriate business structure. While this seems like an advantageous procedural move, it can put financers in a difficult position because the new entity may nor have a business credit rating. This does not necessarily disqualify them from borrowing, but they may have to show a means to guarantee the loan.
Loan-to-Value and Debt-Service Coverage Ratios
Two important ratios that are weighed by commercial real estate lenders are the property’s loan-to-value ratio (the amount of the loan divided by its purchase price or appraised value) and the debt-service coverage ratio (the property’s annual net operating income compared to its debt service, which is comprised of principal and interest.
A good loan-to-value ratio typically falls in the range of 65 to 80%, which a good debt-service coverage ratio should be at least 1.25, indicating positive cash flow. Anything less than 1 indicates cash flow that is negative.
Loan Repayment Schedules
Like standard home mortgage loans, commercial real estate loans are amortized over an agreed-upon number of years that includes interest and fees. A longer amortization period usually means lower monthly payments and higher overall interest paid by the home mortgage holder.
With commercial loans, the amortization period is frequently longer than the length of the loan. This forces the borrower to pay off or “buy out” the remaining balance at the end of their term. These rates can be negotiated between the borrower and the bank, but they can turn upside down quickly, putting the borrower in a difficult situation.
As with all loans, entrepreneurs or investors interested in commercial real estate need to come prepared and have serious business goals and plans lined up when working to secure financing. Knowing these factors and considerations should help you keep a foot in the door!