Introduction to commercial mortgages
Is your business looking to purchase commercial property? Commercial mortgage lenders can provide the funding you need.
Banks and other institutions offer a variety of different lending programs and repayment options so you can select the type of commercial mortgage that best fits your business.
Obtaining a commercial mortgage isn't as easy as getting a home mortgage - it requires a considerable investment, a strong business history, and a large amount of paperwork. First, you must find a building to purchase before you can even apply for a commercial mortgage. Next, you may need to have the property appraised and show proof that the building is environmentally safe. You also must show you can keep up with monthly payments to avoid losing your property.
This BuyerZone Commercial Mortgage Buyer's Guide can help you avoid the most common mistakes commercial mortgage shoppers make by explaining:
- How a commercial mortgage works
- What your responsibilities are
- The types of commercial mortgages available
- How to select the best lender
- What the various costs are
Once you assess your commercial mortgage needs, BuyerZone can immediately provide you with free custom quotes from multiple commercial mortgage lenders.
Benefits of commercial mortgages
Commercial mortgages help businesses get the necessary funding to purchase real estate. If your company has good credit, strong financials and a proven business model, you should be able to qualify for commercial mortgages.
Businesses rely on commercial mortgages to buy land to construct a new building, to purchase an existing building or business, or to acquire multi-unit properties so you can rent space to business or individuals. Examples of commercial real estate include:
- Office buildings
- Apartment complexes, condominiums (four units or more)
- Strip malls
- Retirement homes
- Warehouses, manufacturing plants
- Health care facilities
- Schools, churches
- Car washes, repair shops
- Restaurants, hospitality
Purchasing vs. renting
Commercial mortgages offer several benefits over renting property. One of the most significant benefits is, simply, ownership. Instead of just providing office space for your business, your monthly payments now help build equity. Also, the interest is tax-deductible, which lowers your company's gross taxable income.
With fixed-rate commercial mortgages - loans with an interest rate that doesn't change month-to-month - your cash flow management improves. You can more easily predict your monthly expenses without fear of rent increases. And since commercial property typically appreciates in value, real estate is generally considered a solid long-term investment. When you're ready to shop for commercial mortgages, submit a free request for quotes from our network of brokers.
Another advantage to commercial mortgages is that the loan is generally assumable. This means if you decide to sell the property while still carrying the mortgage, a qualified buyer can take over the terms of your existing loan without needing to go through an extensive approval process.
However, there are significant downsides to consider. Buying is a time consuming process. You must provide significant documentation, including all of your business financials from the last three years. This may include income, rent rolls, business plans, and other proprietary information, and takes weeks for the lender to review. Even after you receive the loan, you may still need to provide regular financial updates to the lender to demonstrate your financial stability.
In addition, you have a fixed cost that you now need to cover, regardless of how your business performs. While a landlord may be a bit more flexible about payments, commercial mortgage lenders won't be.
Finally, as an owner, you'll have increased responsibility to maintain the property, particularly if you sublet space to other businesses. Also, if you're depending on rental income to make payments, you'll have to work diligently to find tenants as units that stay empty for too long can lead to serious financial problems.
Before you begin shopping for a commercial real estate mortgage, you'll have to address several issues to make sure your business is the right candidate. A trustworthy broker can help you determine if a commercial mortgage is right for you, but here are some of the questions you'll need
Can I afford it?
While strong credit and a solid business plan are important to getting a commercial real estate mortgage, the most significant factor the lender looks for is your available cash flow. Lenders look at two key ratios to determine if you can consistently make timely payments - loan to value and debt service coverage.
The loan-to-value ratio (LTV) is the amount you wish to borrow divided by the appraised property value. For example, if you put 25% down and borrow the rest of the purchase price, your LTV is 0.75. The lower the ratio, the better candidate you are for lower interest rates.
Debt service coverage ratio (DSCR) is essentially a "financial cushion" that ensures your property will provide more income than you need to make monthly mortgage payments. Lenders determine your DSCR by dividing your net operating income (NOI) by your monthly interest and mortgage payments. Your DSCR needs to be at least 1.25 or higher to be considered at low risk for a loan.
How much money do I need to get started?
Typical commercial real estate mortgages start at $400,000 to $500,000 or more. To secure a mortgage of this size, your business will need to make a sizeable down payment. Commercial lenders generally require 20% to 30% down payments. Some lenders might accept 10% down if your other finances look strong, but you'll pay a higher interest rate in exchange. And unlike residential mortgages, you can't finance commercial property with "zero money down."
With a mortgage, cash troubles are especially dangerous because the building itself is the collateral for your loan. If you miss payments, or your DSCR falls below 1.25, the bank can foreclose on the building to recoup their losses. If buying a property means overextending your finances, you may want to continue leasing until your business is in a better cash position.
Is my business risky?
While commercial real estate mortgage lenders view apartment complexes and office buildings as relatively safe investments, riskier businesses like gas stations and new restaurants can be more difficult to fund. Such real estate purchases may require you to show a history of success running those kinds of businesses. You'll have to pay the lender for costly environmental tests and extensive research so the lender can determine if your business can succeed. And if you're approved for a loan for high-risk property, you'll likely pay a much higher interest rate. Make sure you understand the risks involved and that your business is equipped to overcome them.
How long a mortgage do I need?
The typical commercial real estate mortgage is 15 to 20 years. You can find mortgages as long as 30 years, which will lower your monthly payment. Of course, the longer you take to pay off the mortgage, the more you will pay in interest.
If you are in a strong position to pay off the mortgage within a few years, be aware of early repayment charges (ERC). Lenders may tack on costly additional payments if you pay off the mortgage early. An ERC can be a considerable unexpected expense, so if you discover that your lender has included one in the mortgage fine print, try to negotiate it out.
Key elements of a commercial real estate mortgage can get confusing. Learn how to avoid many of the misconceptions that commercial mortgage shoppers make.
Getting a commercial property mortgage
If you feel confident that your business meets the finance requirements, you're ready to start the process of obtaining a commercial property mortgage. It can take a few weeks or several months, depending on the appraisal process and negotiations, but typically takes around 60 days.
Steps to obtaining a commercial property mortgage
- Find property. You need to have a building or land in mind before applying for a commercial property mortgage - otherwise a broker cannot help you. If you're buying a rental property, you'll also need to have tenants lined up to show the property will be cash flow positive.
- Find a lender. Once you understand your financial commitment (see "Borrowing considerations"), you should research several lenders, or have a broker match you with multiple lenders to search out the best commercial mortgage rates and terms (see "Choosing a lender").
- Complete a loan application. The application gets the loan process started. You may or may not pay a fee for this process (see "Pricing").
- Provide documentation. The lender will need detailed financial statements from the previous three years, including business and personal records. This includes operating statements, bank records, tax returns and corporate financials.
- Hire a lawyer. Make sure you procure a lawyer's services when purchasing a commercial property mortgage. A lawyer can help you review the terms and conditions of the mortgage and look for any undisclosed fees. The lawyer will also represent you when you close the loan to make sure everything runs smoothly.
In turn, the potential lender will take the following steps to determine whether to approve your business for a mortgage:
- Evaluate your financials. The lender will consider the financial statements you provided, calculate your LTV and DSCR, and decide whether you demonstrate a high probability of being able to repay the loan consistently.
- Perform background checks. Lenders will review your business and personal history and credit to make sure your business is stable and can succeed in the new property. They will also appraise the value of the property and search the title history for any liens, verifying that the seller owns 100% of the property.
- Conduct environmental inspections. Depending on the potential health and danger risks of property, the lender may need to conduct environment inspections. Gas stations, industrial plants, and other businesses that work with potential harmful substances are subject to these inspections. These businesses are typically harder to fund and require more stringent lending policies.
- Approve or deny mortgage. Once all the evaluations are complete, the lender will either approve or reject your application. If they approve the mortgage, they'll start preparing the mortgage documents. If they reject your application, they provide a list of reasons why, and you can try to fix those issues and reapply.
- Underwrite and fund loan. Once the loan is approved, the lender will underwrite the terms and conditions of the commercial property mortgage and arrange funding. Depending on the complexity of your business, this could take a couple of weeks or several months.
Once everything is agreed upon, make sure your lawyer reviews all of the fees and terms listed in the contract to check for inconsistencies. Once you and your lawyer have requested changes and reviewed the final documents, you hand in your down payment at the closing and sign the contracts. The money is typically available within a few days of finalizing the paperwork.
Types of commercial mortgages
Lenders offer multiple types of commercial mortgages. Some are similar to residential mortgages, while others are exclusive to businesses.
Fixed and variable amortized mortgages
If you've ever taken out a car loan or a residential mortgage, you've likely made amortized payments. You pay an equal amount each month, usually 15 to 25 years for commercial mortgage lending. At first, as much as 95% of each payment goes towards interest, but every month you pay a little more towards the principal until the loan is paid in full.
Fixed rate mortgages carry an unchanging interest rate for their entire term. They allow you to lock in rates when they are low, but you must pay that same rate even if the interest rates fall. You can always refinance a fixed rate mortgage if the rates fall significantly.
Variable rate (or adjustable rate) mortgages offer lower initial interest rates than fixed rate loans, but you are subject to fluctuating market conditions. If the rates go down, your payments will be lower; if rates spike, you will make progressively larger payments. Variable mortgages are riskier because they don't allow you to accurately budget for payments from month to month.
Many businesses that provide commercial mortgage lending start with fixed rates for three to five years, then switch to variable rates for the remainder of the mortgage. This type of hybrid loan is sometimes called a two-step loan. This keeps payments predicable at first, delaying any fluctuations until you're better equipped to handle them.
Interest only mortgage
Despite the title, you still must pay the principal balance on this and any type of commercial mortgage lending. "Interest only" simply refers to making payments exclusively towards the interest for the first three to five years. This initially reduces your monthly payments so you can concentrate on improving your cash flow. However, since you're not paying down the principal during this time, your monthly payments will be considerably larger once the interest-only period ends.
Mortgages with balloon payments
If you're looking to stretch your monthly dollar, you can apply for commercial mortgage lending with a final balloon payment. This shorter-term loan - which can range from 5 to 15 years - requires small monthly principal and interest payments. This allows you to use immediate cash flow to grow your business. Your last payment, or balloon installment, includes the remaining interest and principal on the loan and can amount to tens of thousands of dollars or more.
Balloon payments are risky for any business, particularly if you're applying for commercial mortgage lending for the first time. Anticipated growth in your business may or may not arrive on schedule - but the balloon payment definitely will. To avoid problems, you can either negotiate for a lesser balloon payment before agreeing to a loan, or roll the balloon into a new loan with better payment terms when it comes due.
You may qualify for less common commercial mortgage lending types such as endowment mortgages, which are similar to interest-only loans but funded with proceeds from life insurance policies, personal savings accounts, and retirement plans.
If growing your business quickly is the most important to you, hard money loans or bridge loans might suit you better than mortgages. These business loans can provide short-term financing with much less documentation, but higher interest rates. Read our Business Loans Buyer's Guide for more information.
If you have held your current mortgage for three years or longer and would like better terms or a lower rate, consider refinancing.
Refinancing (or "cash-out refinancing") allows you to leverage the appreciation in your property towards expansion or a down payment on a new loan. It's quicker than the original mortgage process because you already have the property and the documentation, as well as experience operating the property. However, if you're working with a different lender than your first mortgage, you'll still need an appraisal and an environmental test, if applicable.
Choosing a mortgage lender
There are three main sources for obtaining a commercial mortgage: banks, third-party lenders, and commercial mortgage brokers.
Banks are the most common choice. They typically offer the lowest rates, but may only work with certain industries or purchases. They also require the most documentation and may charge more fees than other lending sources.
Third-party lenders (also known as hard money lenders) can provide mortgages more quickly and with less documentation. The money comes from private sources, insurance companies, or warehouse lines of credit. Third-party lenders charge a significantly higher interest rate than banks.
Commercial mortgage brokers don't provide mortgages directly. Instead, they investigate many banks and lenders to find you the right mortgage at the most competitive price. The broker fosters relationships with lenders so they can get you deals you might not be able to get on your own. Brokers also do much of the research and background checking which saves you the time and effort of shopping around.
However, broker service comes at a price. Unlike brokers for residential mortgages, commercial mortgage brokers receive a commission based on a percentage of the total amount borrowed in addition to your mortgage-related expenses. Brokers that specialize in specific industries may also charge more for services. If you have a reliable lender in mind, or you're willing to invest the time to do research, you can shop several lenders without paying broker fees.
Selecting the right lender
Consider the size and experience of each commercial mortgage broker. Businesses that offer both residential and commercial loans may be less expensive, but may not offer the same success rates and experience as a dedicated commercial mortgage company. Also, if a mortgage company has offered commercial loans for many years, it's usually a strong indicator that they provide solid service.
When looking for the right mortgage source, look for specialist lenders or brokers that focus on the types of buildings you're looking to buy. If you're purchasing an apartment complex, for example, a lender with previous experience working with apartment building sales may find you better mortgage rates and terms. It may cost you more, but the added guidance and time savings can make up for the expense.
Don't automatically work with the first lender a commercial mortgage broker matches you to. Make sure the broker provides you with three to five potential lenders. Then perform some due diligence of your own to find out about each lender's history, corporate stability, and lending policies and procedures before selecting one that best fits your interests. If possible, get references from those lenders and talk to those borrowers about their experiences to help make your final decision.
Lenders should be willing to negotiate. While mortgage rates are often non-negotiable, reliable lenders may be able eliminate or reduce certain fees to earn your business. However, don't shop on cost alone. If a lender can't budge on costs, but offers the best service from beginning to end, it may be worth the additional cost.
Avoid working with any lender that discourages you from shopping around. Reputable lenders want to earn your business by offering competitive terms and excellent service - not by preventing you from talking to competitors.
Finally, if a commercial mortgage broker already provided you a rate in writing, make sure to let subsequent lenders know. The lenders don't want to spend a great deal of time and resources processing lengthy paperwork if you are simply shopping around.
Commercial mortgage rates and costs
The interest rate is the most important pricing component of your commercial mortgage rate. Lenders base their interest rates on the prime rate - the rate banks offer to large corporations and the most creditworthy borrowers. As of November 2009, the prime rate is 3.25% - but for a more realistic picture, take a look at commercial mortgage rates reported by BuyerZone users.
A lender typically charges prime plus a percentage of the total loan amount that can range from half a percent to several percentage points. The rate will vary greatly based on several factors such as the size of your down payment, the length of your loan, the location of the property, and the risk level of your business. You may be able to get a lower fixed percentage for the first few years before it becomes a larger variable percentage later on.
If you only qualify for a high interest rate now, you can refinance your commercial mortgage rate with another lender once your business improves. Since most businesses refinance with a different lender, you can qualify for a better interest rate, but may still be responsible for many of the same fees as a new commercial mortgage.
Another significant expense is the down payment - 20% to 30% of the purchase price. However, that money immediately becomes equity in the property. You can put less than 20% down, but it will considerably increase your interest rate.
Completing the process Before you sign a single document, make sure you negotiate better interest rates or longer mortgage terms with the lender. Since you will likely make payments on the property for several years, you need to be happy with the terms and conditions. Even if you can't negotiate a lower commercial mortgage rate, see if the lender can decrease or eliminate certain up-front costs, balloon payments, or early redemption charges.
In addition to the monthly payments, you'll also be responsible for several up-front fees that can total tens of thousands of dollars and possibly hundreds of thousands of dollars. Make sure to budget for these closing-related fees above and beyond your monthly commercial mortgage rate payments.
- Valuation fee. Appraising the value of the property can cost from $1,200 to $4,500 depending on the size of the property. If you're buying land to build on, these fees may be several thousand dollars more as they must make sure the land can accommodate your building needs.
- Environmental surveys. Buying potentially dangerous property, such as a gas station with underground fuel tanks, requires more stringent inspections. A Phase I environmental inspection typically ranges from $200 to $4,500. If the building requires a more intensive Phase II inspection, expect to pay $3,500 to $10,000 or more.
- Due diligence. The lender will run several credit and background checks to gauge your credit worthiness. This can cost several hundred to a few thousand dollars depending on the time and work involved.
- Broker fees. If you work with a broker, expect to pay one-half to two percent of the loan value for his or her services. If it's a particularly large loan (several million dollars), the fee will be on the lower end. If the broker helped you get a short-term hard money or bridge loan through a third party lender, the fee could be as high as 5% to 7% or higher.
- Legal costs. You may spend a few thousand dollars on a lawyer to review the contract, check for hidden charges, and ensure that the inspection work was done properly.
- Additional fees. Up-front charges such as application fees ($300 to $500) and processing fees ($500 to $2,000) may be optional based on the lender's discretion. Some lenders use the derogatory name "junk fees" because they feel such charges are unnecessary, while others feel these fees demonstrate that the borrower is serious. In some cases, the lender may refund these fees at closing.
Early repayment charges and balloon payments
Two other fees to keep in mind are early repayment charges (ERC) and balloon payments. As previously mentioned, both fees are negotiable but it's up to the individual lender.
- Unlike with other large purchases, it's not always necessary to meet a lender in person to close a commercial mortgage. If you do the necessary research on their license, background, and references, you can iron out the details by e-mail, phone, and fax. Not having face-to-face interaction with the lender makes it even more important to have a lawyer oversee the process.
- Are you concerned about a broker's ability to deliver enough value? Use the "one-point" test. If a broker can't save you at least one percentage point, (from both money and time savings), look for another broker or go to a direct lender.
- Don't rush to take out a hard money loan. Even though it seems appealing to provide less documentation and avoid many mortgage restrictions, hard money loans can get very expensive - as much as 5% of the loan value up front with 15% to 20% interest - and may hamper your ability to get a commercial mortgage in the future.
- If you own property but want to relieve yourself of the responsibilities that come with it, you can enter a "sale and leaseback" agreement with another buyer. The new buyer can assume your current mortgage, and then lease it back to you.
- Commercial mortgage lenders don't provide funding for startup businesses. If you're looking to launch a company, you may want to look into Small Business Administration (SBA) loans. SBA loans provide entrepreneurs with fixed rates to start new businesses.
- Don't start looking for property before you've spoken to someone about financing. You may not be able to afford as much as you'd like. Also, commercial financing often takes more time to complete than a residential mortgage.