Most Common Types of Commercial Real Estate Loans
Those looking to buy real estate generally must rely on a commercial real estate loan to complete the transaction – most individuals do not have excess capital to cover the purchase. Real estate loans, however, are not one-size-fits-all. Rather, a variety of loans are available for today's investors, and the one they choose depends on their position, their qualifications, and the intended use of the property. Here, we introduce the nine most common types of commercial real estate loans used in 2022.
What is a commercial real estate loan?
As the name implies, a commercial real estate loan is used to purchase commercial property – real estate used for business (income-generating) purposes – as opposed to residential property, which is used for housing. Commercial real estate includes office buildings, apartment complexes larger than four units, hotels, retail buildings, and more.
Who can purchase commercial real estate?
Anyone can purchase commercial real estate, although the reason may vary. Some investors buy commercial real estate strictly for investment purposes, often holding the property long-term or leveraging a value-add strategy. Developers may seek land to construct new commercial buildings, while business owners may want to acquire a new asset for their operations. Essentially, anyone looking to leverage the benefits of real estate ownership can purchase commercial property.
How are commercial real estate loans different for individuals vs. entities?
Commercial real estate loans are generally made to entities such as corporations, limited partnerships, funds, and trusts. However, individuals can also apply for a commercial real estate loan. In fact, many individuals create entities specifically to acquire commercial property.
Different Types of Commercial Real Estate Loans
A variety of commercial real estate loans exist. Following is more information about the various types of loans available today.
1- Traditional Model Loans
A traditional model loan is the most common type of commercial real estate loan. It is similar to a residential property loan used to purchase a single-family home, which typically has a fixed rate over 30 years. A commercial loan, however, often has a shorter term (5 to 15 years) and a variable rate. When applying for a traditional commercial real estate loan, investors may be required to put down 25 percent of the purchase price. Prior to issuing a loan, the lender appraises the property and consults financial forecasts to determine whether the debt service can cover existing rates.
2- SBA Loans
SBA loans are small business loans partially guaranteed by the U.S. Small Business Administration (SBA) and issued by participating lenders, usually banks. These loans have tight lending standards, but their flexible terms and low interest rates make them attractive, especially to investors who have been denied traditional funding. Currently, the SBA offers two loan programs for commercial real estate investments: SBA 7(a) and SBA 504 loans.
SBA 7(a) loans are more common and can be used to purchase or refinance owner-occupied commercial real estate at any amount up to $5 million. To qualify, investors must have good credit and put down at least 10 percent of the property’s purchase price. The term of the loan can be up to 25 years, and interest rates can vary based on current market conditions and the applicant's qualifications.
SBA 504 loans are similar to their 7(a) counterparts; however, there is no limit to how much an investor can borrow. Investors must have good credit and provide a down payment of 10 percent of the purchase price. The term of the loan is typically 20 years, and the investor must occupy at least 51 percent of the property. Unlike SBA 7(a) loans, these mortgages are not funded entirely through a private lender. Instead, they are made available through Certified Development Companies (CDCs), nonprofit entities that promote economic development within their communities. Typically, a commercial lender funds 50 percent of the project, and a CDC finances up to 40 percent.
3- Commercial Bridge Loans
Investors may turn to a commercial bridge loan as a short-term financial solution. Because it is short-term (usually 1 year or less), this type of loan tends to have a higher interest rate than a traditional commercial real estate loan. The goal of the loan is to provide funds and sustain cash flow while an investor improves, refinances, or leases up a commercial property. It can also be used while an investor is waiting to secure long-term financing or to cover a balloon payment on a loan.
4- Commercial Hard Money Loans
Hard money loans are one of the most expensive sources of financing for commercial real estate – with interest rates between 10 and 20 percent. These loans are issued by private companies or individuals and typically require little proof that an investor can repay the loan. Instead, lenders are more concerned with the value of the property. This type of loan is secured using the property as collateral. If an investor defaults, the lender makes money back by selling the property. The approval process to obtain this type of loan is much faster since few underwriting regulations exist. However, the investor must repay the money in a short amount of time, usually within 1 to 5 years.
5- Commercial Mezzanine Loans
Similar to a commercial hard money loan, a commercial mezzanine loan uses commercial property as collateral and allows the lender to convert debt into equity in the event the investor defaults. If the investor fails to pay off the loan promptly, the lender has the right to take a portion of the investment property and sell it to pay the debt. Commercial mezzanine loans can be structured in various ways, including junior debt, preferred equity, convertible debt, or participating debt.
Investors typically use junior debt as the second source of capital and repay it after the initial loan is paid in full. They can use this type of loan for new acquisitions or to further develop the property.
Under preferred equity, investors receive certain privileges in exchange for investing. These privileges can include priority return of capital or a higher rate of return than “common” equity investors. In the event of a sale or liquidation, preferred equity holders generally have priority over common equity holders.
Convertible debt occurs when an investor borrows money and plans to convert it into equity or ownership in a company at a later time. The investor and lender decide the type of equity and a set time when the loan converts based on the company’s value when the loan begins. Typically, convertible debts are paid with converted equity within 1 to 2 years.
Under a participating debt agreement, investors receive interest payments and a share of the rental revenue generated on a commercial property if it exceeds a certain amount. This type of debt is often used to finance properties that have reliable tenants.
Regardless of the type of debt incurred under a mezzanine loan, lenders are considered secondary to the primary lender if the mortgage defaults. To account for the increased risk, the cost of mezzanine capital tends to be much higher than for a traditional loan.
6- Take-Out Loans
A take-out loan is a type of long-term financing that replaces short-term interim financing. For example, if investors use a construction loan to build a new property, they can use a take-out loan to replace the construction loan once the property has been fully built. This type of loan might require the investor to make smaller payments at a lower interest rate over a longer period. In exchange, the lender might require the investor to share a part of the rent earned from the property or a percentage of the gain acquired if the property is sold.
7- Permanent Loans
Despite its name, a permanent loan is generally not permanent, although it may last an unusually long time. A permanent loan is a first mortgage on a piece of commercial property and is offered by most commercial lenders. It most closely resembles a consumer mortgage with a fixed or variable rate.
8- Blanket Loans
Investors planning to buy more than one property may want to consider a blanket loan. This type of loan makes it easier for investors to get financing for multiple properties rather than having to take out individual loans. However, blanket loans have some disadvantages. For instance, it can be difficult to sell off an individual property since they are all tied together. Moreover, if an investor decides to unload a property and fails to sell it at the expected price, all other properties may be in jeopardy since they are joint collateral.
9- Business Line of Credit
A business line of credit allows an investor to borrow a certain amount of money while charging interest only on the amount of money borrowed (like a credit card). A line of credit is unlike a traditional loan where investors are given a lump sum of money they pay back with interest in monthly payments. For sudden expenses, cash-flow needs, and major purchases, a line of credit allows investors quick and easy access to available funds.
How does an individual qualify for a commercial real estate loan?
Qualifying for a commercial loan depends on how much capital an individual or entity has for a down payment, the reason for purchasing the asset, whether the property has an existing tenant, along with various other factors. To determine how one can qualify for a commercial loan, it is best to speak to multiple qualified brokers or lenders – asking questions and learning about the opportunities that exist for the proposed business plan. Once investors have done due diligence, they can apply for the loan that helps them accomplish their overall goals.
You might also like...
5 connectivity questions to ask before signing a commercial lease
Connectivity is crucial for success! While connecting with the right landlord and your target customer base is important, today's blog actually ...
What Class of Commercial Real Estate Is Best for Your Business?
Retailers must weigh their options when searching for a local space to rent and consider what space is optimal for their business. One major question ...
How to be a good tenant when leasing commercial space in Clinton Hill
Even with online retail and social media marketing on the rise, your physical location plays a vital role in the success of your business. The ...