Commercial Mortgage Loans: A Way to Finance Commercial Real Estate

Almost every business need a physical place to carry out the operations from. Some entrepreneurs, especially the ones involved in online businesses tend to use their home as their place of work but the majority of startups and small businesses will need dedicated real estate.

It’s very unlikely that you would have enough money to cover the entire cost of purchasing a commercial property as a small business owner. Business mortgage loans exist to make the price tag of such properties a lot easier to manage.

The same holds true for developing and renovating your commercial property as well. This allows you to focus your cash flow in other expenses without draining it out completely.

How is a mortgage any different from a loan?

The majority of business owners tend to call or refer to a mortgage as just another loan but in actuality, both are quite different from one another.

A loan is a sum of money that a lender gives you whereas a mortgage is a document that protects the lender’s investment in financing your commercial property.

In a loan agreement, you, the borrower, will be referred to as the “mortgagor” and the lender will be referred to as the “mortgagee”.

The mortgage document will provide security or collateral in the form of a property. So if you are not able to pay back the loan within the given time-frame, the lender will have the right to seize your property and recoup their losses.

What’s the difference between a commercial and residential mortgage loan?

In order to quality for a commercial or business mortgage loan, you need to be purchasing, developing or renovating commercial real estate such as an office, warehouse or storefront.

A residential mortgage loan however, is issued when you are purchasing, developing or renovating residential real estate such as a house or apartment.

For a property to be considered as commercial property, a business must use it to earn or generate income. For example, commercial property of a retail business would be its storefront.

Even if you are engaged in an online business, the office where you and your employees work from can be considered as commercial real estate.

Benefits of a commercial mortgage loan

A property’s value increases over time. A commercial mortgage loan can help future-proof your business by giving access more and more equity as time passes. In one way you can look at commercial mortgage loans as a source of finance for your business.

You could even rent out the entire or parts of the property after purchasing it with a commercial mortgage loan. This will increase the monthly cash-flow of your business.

You could use such a loan to purchase an existing company as well. Last but not least, the interest part of the repayments is tax-deductible.

Factors that influence the chance of approval

Since the application screening process differs from one lender to another, it’s really hard to say which factors they would look at when approving your loan but below are the most common and obvious ones.

• LTV Ratio

The LTV or Loan To Value ratio measures the value of the loan against the value of the commercial property you are going to purchase.

Lenders typically require borrowers to cover 20%-30% of the property’s purchasing price while the rest is to be covered by the loan amount.

The more down payment you are able to put in, the lower your LTV ratio. And the lower your LTV, the more likely your loan would get approved.

• Collateral

A commercial mortgage loan requires collateral in the form of commercial property to use as a medium to recover the loan amount in the case where the borrower is unable to make the monthly payments. Therefore, the lender may require a complete assessment of it.

You could try submitting additional collateral such as contracts, receivables or a personal guarantee of repayment to increase the likelihood of being qualified. While this may work, it puts more of your assets at risk.

• Credit score

A good personal and business credit score will definitely improve your chances of getting the loan approval but it won’t have as much impact as it would have in a residential mortgage loan.

On the other hand, a poor credit score will certainly send a negative signal to the lender and would probably result in your application being rejected. You would need at least a credit score of 660 in order to quality for good rates.

The lender will check whether any of your previous businesses have gone bankrupt or any foreclosures have been made in the previous loans acquired as well.

• Liquidity

Most lenders require a reading on the monthly cash-flow of your business to make sure that you are able to put in the necessary down-payment without completely exhausting your cash-flow.

Not only that, they would want to know whether you have enough cash to make the loan repayments on time as well.

Although the exact liquidity requirement will differ from lender to lender, a good rule of thumb is to have at least 15% liquidity when compared to the loan amount.

For example, if the loan amount is $100,000, your cash liquidity must be at least $15,000 and your monthly average cash-flow must be enough to cover the monthly installments, plus the interest.

Rates

Interest rates of commercial mortgage loans are much higher than that of residential mortgage loans. The reason being the risk involved in lending money to a business.

Most businesses, especially startups, tend to have less established credit histories than individuals. So as compensation, lenders require a higher interest rate than usual.

Fees

There are certain upfront fees involved with commercial mortgage loans that you should know about before continuing with the application form. They include expenses incurred during the appraisal of the property, application fee, origination fee, legal fees and etc.

Lenders may ask for those fees at different stages of the loan. Some may ask for them before the loan is approved, some after and some at the end of the first year of the repayment period.

Check whether the lender has mentioned about any prepayment fees in the loan agreement so that you can avoid paying off the loan before the repayment period ends.

Repayment

There are two repayment schedules for commercial mortgage loans; short-term and long-term. A short-term loan will only give you 2 years or less to pay off the loan in full whereas a long-term loan lasts for up to 20 years.

The more you extend your repayment period, the more monthly payments you have to make and the more money you will waste as interest. However, it will make the monthly installments much more bearable.

Next, clarify which repayment structure the lender wants you to follow. These are of two types; amortized loan and balloon loan.

An amortized loan is where you make fixed installments (plus the interest) over a fixed number of months until the end of the repayment period to pay off the loan in full. A balloon loan however, is a loan that you pay off with one big payment at the end of the repayment period. You will only have to pay the interest each month.

The way you pay back the loan has a big impact on your cash-flow and reserves. For example, an amortized loan lets you pay back the loan in smooth monthly installments until the repayment period comes to an end.

This way you won’t have to exhaust all your cash reserves by paying off the loan in one big payment. On the other hand, a balloon loan lets you loosen up the cash flow of your business by only requiring you to pay the interest each month.

Commercial mortgage loans for startups

Startups usually have little to no trading history, reputation and revenue, and are much riskier than small businesses that have been conducting business for several years.

So how can you get a business mortgage loan if you own a startup that has no existing real estate? In such cases, the lender will allow you to use your existing residential property as collateral.

Securing the purchase of a commercial property will hold certain financial benefits in the long-run of your business. When the property’s value goes up, the capital of your business does too. You could then sell or refinance it in the future when further funding is required.

The application process of a commercial mortgage loan

You may think the application process of a commercial mortgage loan is similar to a residential mortgage loan but trust me, it’s nothing alike.

Residential mortgage loans are easier to qualified for since they are backed by the National Mortgage Association, whereas commercial mortgage loans are not.

The lender would require you to submit certain documents and reports belonging to your business. This is done because lending money to a business is much more riskier than lending money to an individual, especially if yours is a new or small business.

Refinancing commercial property

Refinancing means paying off one mortgage and replacing it with another on the same property with the hope of getting better rates.

This will only work if your business owns or part-owns commercial real estate and if its value has increased substantially since the last time you mortgaged it.

refinancing allows you get better rates so that more cash will be freed up in your business every month.

Submit clear and in-depth financial projections and balance sheets to influence the likelihood of you getting better rates and higher capital than last time.

In addition, you can refinance a property to simply switch from having to pay a variable interest to a fixed monthly interest, the latter being the better. Fixed rates are preferred because it’s easier to strategically plan out the expenses in financial projections.

It can release the equity bundled inside commercial property, enabling you to invest that money in new projects, new products or to expand business operations.

It can be used to consolidate debt as well. You could use the equity released from your property to pay off previous debt. This way, you will only have to make one repayment each month instead of making multiple payments to multiple lenders.

Difficulties in refinancing

Don’t think refinancing your property would take any less time than before. It may take up to three months for you to hear anything back from them.

You may be required to pay a prepayment fee for paying off the loan earlier than agreed. This fee will act as compensation for the interest payments they lost in the coming months.

You may also be required to gather and submit a lot of financial documents such as balance sheets, profit and loss statements, projections and sales forecasts. Some lenders may require the financials of directors and key shareholders of your business as well.

Despite everything, once it’s done you will be able to minimize the number of monthly debt payments and increase liquid cash.

Conclusion

Taking out a commercial mortgage loan will not only cost you collateral but also time. The processing time is not as fast as with invoice factoring or credit card stacking, in fact, it may take as long as three months to hear back from the lender.

Make sure you are capable of making the loan repayments without completely exhausting your cash-flow. One solution would be to get the lender to extend the repayment period of the loan, thereby reducing the monthly payable amount.

And read the loan agreement thoroughly before signing on the dotted lines. After signing it, it’s already too late. Especially watch out for the rates and fees you are required to pay throughout the lifetime of the loan.

Finally, use an online calculator to check how much you would have to pay each month, including the interest, for a business mortgage loan with terms you prefer.

What hardships have you come across while trying to qualify for a commercial mortgage loan? Let me know in the comments section below.