Finance
Commercial Real Estate Financing Fundamentals
Interested in taking out a commercial real estate (CRE) loan but don’t know where to start? This guide is for you. Read on to learn the fundamentals of CRE financing and how to qualify for it.
What is CRE Financing?
CRE financing refers to funding commercial real estate investments—whether through raising equity from limited partners (LPs) or taking on debt, though it usually means the latter.
Unlike a residential mortgage, CRE loans are designed for investors, flippers, and builders (not homeowners). They can be used to purchase, develop, renovate, or refinance various kinds of commercial property, such as offices, retail stores, multifamily buildings, warehouses, and more.
CRE Loan Types
Here are the most common CRE loan types to consider:
Permanent Loans
Permanent loans are long-term mortgages best for fully leased properties with stable cash flow. They typically have fixed interest rates and loan terms of 5-20 years amortized over up to 30 years. If the amortization period exceeds the loan term (which is common), a balloon payment is due at maturity.
Bridge Loans
Bridge loans are short-term loans designed to “bridge” the gap between a property’s acquisition and its eventual resale or long-term financing. For example, some CRE investors take out bridge loans to fund fix-and-flips. Once the rehab is complete, they stabilize the property with fresh tenants and refinance it into a permanent loan or resell.
Typical bridge loans have 6-24 month loan terms, during which borrowers make interest-only payments before paying off the loan balance with a balloon payment at maturity.
Construction Loans
Construction loans are similar to bridge loans, except they’re designed for developing commercial properties from the ground up.
The borrower either owns or finances the land with a separate (or integrated) land loan. The construction loan then finances the construction process (material, labor, etc.). Typically, construction loan funds are dispersed according to an agreed-upon draw schedule.
SBA Loans
The Small Business Administration (SBA) offers two popular CRE loan programs: the SBA 7(a) loan and the SBA 504 loan. Both are backed by the SBA, while a private-sector lender issues the actual loan funds (up to $5 million for SBA 7(a) and up to $5.5 million for SBA 504).
Since SBA loans are guaranteed by the government, they pose less risk to the lender, and borrowers can often secure favorable loan terms as a result.
Hard Money Loans
Hard money loans are short-term 6-24 month loans backed by a “hard” asset (almost always the property being financed). In addition, they’re issued by private lenders who care more about the asset’s current and expected value than the borrower’s income or creditworthiness.
As a result, hard money loans can be a great option for businesses with irregular income or poor credit. While interest rates tend to be higher than conventional CRE loans, underwriting takes less time since hard money lenders are subject to fewer lending regulations.
Key CRE Financing Terms
Here are common financing terms that apply to most CRE loans:
Loan term. This is the duration of the loan—from when funds are first disbursed to when the loan must be fully repaid or refinanced. Most CRE loan terms are 5-10 years.
Interest rate. This is a percentage of the loan balance charged by the lender. It can be fixed or variable (aka a floating interest rate).
Amortization period. This is how long it would take to pay off the loan with monthly payments. Many CRE loans have due dates before the amortization period ends, resulting in a balloon payment at maturity.
Origination fee. This is a fee charged by the lender for processing the loan application. It’s typically 0.5% to 1% of the total loan amount.
Other fees. Many CRE lenders charge additional fees for appraisals, closing, or even paying the loan off early (aka prepayment penalty).
Basic Loan Qualification Requirements
To qualify for a CRE loan, you must meet basic criteria set by the lender.
For example, many lenders set a maximum loan-to-value (LTV). This is a ratio that compares the loan amount to the property’s value by dividing the former by the latter (LTV = Loan Amount / Property Value). An 80% LTV limit means the lender is only willing to lend up to 80% of the property’s value. In other words, the borrower must put down 20%.
For permanent loans, lenders often require a minimum debt-service coverage ratio (DSCR). It’s calculated by dividing the property’s net operating income (NOI) by its debt service (DSCR = NOI / Debt Service). If a lender requires a 1.2 DSCR, it means the property’s cash flow must be enough to cover 1.2X the debt service.
Finally, many CRE lenders require the borrower to have a minimum credit score, provide a personal guarantee, and demonstrate a positive track record of past CRE investments.
Pre-Qualification Guide
Now that you know common CRE loan qualification requirements, you’re ready to pre-qualify:
- Start by getting your finances in order. Check your business’s credit and ensure its financial documents (income statements, balance sheets, etc.) are up-to-date and accurate.
- From there, research the subject property’s current and projected value, cash flow, and risk factors. This will help you determine whether it will meet the lender’s LTV and DSCR requirements.
- Lastly, prepare an investment plan and exit strategy. Show how the property will generate income and meet projected return metrics.
Loan Preparation Checklist
To increase your chances of getting approved for a CRE loan, complete the following:
Gather and submit required loan documents, such as business financials, property information, legal documents, etc.
Line up contractors to perform any necessary renovations or construction. Make sure to get detailed quotes on cost and time.
Set aside funds for the down payment and additional reserves for unexpected costs.
Obtain necessary permits. Confirm that the property is zoned for your intended use and meets local building codes.
Frequently Asked Questions (FAQs)
What is CRE financing?
CRE financing refers to funding the purchase, development, rehab, or refinance of commercial properties—usually through a loan.
Are CRE loans fixed or floating?
CRE loans can be fixed or floating. It all depends on the lender’s terms and the borrower’s preference.
What does CRE stand for in finance?
In finance, CRE stands for commercial real estate.
What are typical terms for a commercial mortgage?
Commercial mortgages typically have loan terms of 5-10 years with amortization periods of up to 30 years.
The Bottom Line
CRE financing can be a great way to fund your next investment. Now that you know the basics of how it works, you’re better positioned to secure a favorable loan.
