If you are just getting started with commercial real estate investments, it is essential to have a clear understanding of commercial real estate loans, or CRE loans. Loans for commercial property do have similarities with residential mortgages, but there are also many ways in which they are different. Before diving into the commercial real estate market, take the time to learn about how these loans work.
Commercial real estate investments are typically made on behalf of a business entity rather than an individual. Even if you are investing solo, it is advisable to establish a business entity in order to keep your personal finances separate from your business interests.
You will need to investigate potential financing sources for CRE loans, such as banks and credit unions, which are better suited to first time investors. It could also be helpful to check out commercial loans available through the Small Business Administration (SBA). Look at what sort of documentation will be required in order to qualify for financing, such as financial statements and tax returns.
Lenders use the same loan-to-value (LTV) ratio for commercial real estate loans as they do for residential mortgages. However, while the LTV ratio for a residential mortgage may be 80% or even higher, expected LTV ratios for commercial property are lower, with 80% being the high end. Some LTV ratios can be as low as 50-60%. Borrowers should be prepared to make a larger down payment or obtain additional tiers of financing.
Because CRE loans are generally used for income-generating property, another ratio is also used by lenders to evaluate borrowers. This is the debt service coverage ratio (DSCR), and it quantifies how easily the income generated by the property will cover the debt associated with the loan. To calculate DSCR, take the annual rental income from tenants of commercial property and subtract the operating expenses for the property. Then divide by the annual cost of the loan. Lenders often require a DSCR of 1.15 to 1.35.
Finally, commercial real estate loans have repayment periods from five to 20 years, and there may be penalties for paying off your loan early. The longer the repayment period, the higher the interest rate is likely to be.
Entering the commercial real estate market can be a daunting proposition, so it is quite helpful to educate yourself in advance. If you take the time to get comfortable with the ins and outs of CRE loans, that can make it far easier on you as an investor in the long term.