Want to understand how commercial mortgages work in the US? We will cover everything from definition, different types, and more!
Buying a commercial property or expanding a business location often requires more funding than most people have on hand. A commercial mortgage offers a way to secure the property without paying the full amount upfront. However, this type of mortgage is different from traditional home loans.
Want to know more about them? In this article, Mortgage Professional America will shed light on commercial mortgages and discuss how they work. We will talk about its purpose as well as the common types of commercial mortgages in the market. We will also explain who qualifies and more.
To our usual pool of readers who are mortgage professionals, this is one of our client education pieces. We highly encourage you to share this guide with clients who are interested in commercial mortgages!
What is a commercial mortgage loan?
Commercial mortgages are loans used to buy or refinance properties that are intended for business use. Some examples include:
- warehouses
- retail stores
- office buildings
- apartment buildings
- restaurants and cafes
- industrial facilities and factories
Unlike residential mortgages which help homebuyers, commercial mortgages focus on properties that generate income. Banks and mortgage lenders look closely at the property's income and the borrower's business stability.
Commercial mortgages involve different terms, rules, and approval processes compared to home loans. Understanding these differences can help property buyers come up with the right mortgage product for their commercial needs.
What’s the purpose of a commercial mortgage?
Just like traditional residential mortgages, the funds are borrowed and secured against the property for commercial mortgages. These can also be used to expand an already existing business, for either commercial or residential property development. If you want to finance any sort of business development plan, commercial mortgages tend to be the principal resource.
A commercial mortgage is also structured for borrowers as well as banks and mortgage lenders. Compared to renting, the borrower hopes to benefit through reduced repayments. On the other hand, the mortgage lender wants to see security in their loan.
To better understand how commercial mortgages work, watch this video:
Another way to learn more about this mortgage type is to hire the services of a commercial mortgage broker.
What are typical terms for a commercial mortgage?
Unlike residential loans, commercial mortgages tend to have shorter terms. However, they usually cost more. Down payments often range from 20 percent to 30 percent of the property’s purchase price. Interest rates are also higher, typically falling between 10 percent and 20 percent for most borrowers.
Types of commercial mortgages
Commercial mortgages, also called commercial real estate loans (CRE loans), can be used to buy existing commercial properties. They can also be used for refinancing purposes. There are many types of commercial mortgages and here are some of them:
- conventional commercial real estate loan
- SBA loans
- commercial bridge loans
Here is a closer look at each:
1. Conventional commercial real estate loan
A conventional commercial real estate loan is the most straightforward type of commercial mortgage. It is backed by commercial property and issued by traditional financial institutions. These include banks, credit unions, and other mortgage lenders.
Unlike government-backed loan programs, conventional commercial real estate loans are financed directly through private mortgage providers. This type of commercial mortgage depends mainly on the borrower's financial profile and credit score. It can also depend on the property’s value.
Conventional commercial real estate loans are available through partnerships with different mortgage lenders. Approval depends on several factors such as loan-to-value (LTV) ratios and the borrower's credit strength.
Loan terms usually range from 5 to 30 years with fixed interest rates. In many cases, there are no balloon payments. Some mortgage lenders also offer amortization or interest-only options with terms extending up to 20 years.
Personal and business income are important factors in determining eligibility for a conventional commercial real estate loan. You can expect that you’ll be required to submit tax returns for both your business and personal finances. Mortgage lenders use these documents to verify income and determine if you qualify for the loan.
2. SBA loans
From the name itself, Small Business Administration (SBA) loans are aimed at small businesses. This type of CRE loan is backed by the federal government. This means that the government will pay for a portion of your outstanding balance if you default.
This arrangement provides the bank or mortgage lender with an added layer of security. SBA loans also feature lower interest rates and longer terms.
To qualify for an SBA loan, here are some requirements for your business:
- must operate for profit
- must be creditworthy
- must be able to repay
- must have a sound business purpose
- must operate within the US
- must meet the SBA’s size standards
- must show a need for financing
- must not have outstanding debts with the government
- business owners must not be currently on parole
There are other qualifications that you must meet to be eligible for an SBA loan. The mortgage lender will provide you a full list of eligibility requirements once you connect with one using SBA’s Lender Match.
Watch this to find out more about SBA loans:
3. Commercial bridge loans
Another type of commercial mortgage offers a short-term financing solution. Commercial bridge loans provide an influx of funds until the borrower secures a more stable form of financing. This type of loan is used by those who require money to buy property but are also awaiting the sale of an additional property.
In other words, a commercial bridge loan helps cover cash flow gaps between the time you need the money and when longer-term financing becomes available. Many businesses use commercial bridge loans to repay an existing loan while waiting for a new permanent loan to close.
This commercial mortgage type is secured with collateral, such as the property you are buying or renovating. The amount you can borrow depends heavily on the value of your collateral. Mortgage lenders use an LTV or loan-to-cost (LTC) ratio to determine how much they’ll lend.
Because the loan is based primarily on collateral value, it can be more flexible with credit scores and income requirements.
How to get approved for a commercial mortgage
Since you’ll be using the property for business purposes, banks and mortgage lenders will want to verify your ability to repay the mortgage. They will also review whether your business revenue is good enough to cover the loan payments.
Like traditional loans, commercial loan providers will determine your pre-qualifying potential before you fill out the application form. This involves evaluating your financial information.
Traditional mortgage lenders look at your financial statements—such as income tax returns and banking statements—to determine business stability. Most lending institutions that offer commercial mortgages will also want to see your business plan projecting earnings.
Here are the main factors that mortgage lenders review when deciding eligibility:
- security
- income
- credit
Let’s take a closer look at each:
1. Security
Banks and mortgage lenders want to be certain that the commercial mortgage is secured by the property you’re borrowing against before they approve your application. Generally, you must have around 20 to 30 percent equity in the property.
Mortgage providers will also want to confirm that you have the proper property insurance in place to protect against damage. They will complete a title search on the property and review the deed carefully. This is to confirm that there are no outstanding liens or other claims that could affect ownership.
2. Income
You must also show that you have enough income compared to your expenses to make the loan repayments every month. One way to calculate this is through your debt-service coverage ratio (DSCR). While the minimum varies depending on the property you are borrowing against, most lending companies will require a minimum of 1.25 DSCR.
To verify income, you'll need to provide two years of business and personal tax returns. Additional documentation can include:
- business' organizational documents
- operating agreements
- personal identification: W-9, passport, birth certificate
3. Credit
Mortgage lenders usually check your business credit score when you apply for a commercial mortgage. They might also require a personal guarantee. This means that they’d want to review your personal credit history as well.
Generally, a minimum credit score of 660 is required for commercial real estate loans. However, mortgage lenders might require a score of 680 or higher.
To assess your credit risk, mortgage lenders will look at how long you have been in business. Most want businesses to be operating for at least one to two years before approving a loan. This helps confirm that your business can generate enough revenue to cover monthly mortgage payments.
Getting your commercial mortgage approved
Getting approved for a commercial mortgage requires dedication and effort. You must organize your documents ahead of time and choose the right property that meets your business goals. Mortgage lenders want to work with borrowers who can show steady income and good credit history.
Remember, the better prepared you are, the easier the application process will be.
Finally, with a competent mortgage broker, securing a commercial mortgage can be less of a hassle. If you haven’t hired one, you can check out our Best in Mortgage page to see the leading mortgage professionals in and out of the country!
What do you think about this guide to commercial mortgage? Tell us about your insights in the comments below.
