How to Choose a Commercial Real Estate Mortgage Loan

By: , Contributor

Published on: Dec 17, 2019

Finding financing for commercial properties isn’t always easy.

One of the best advantages of commercial real estate compared to other investments is the ability to leverage it with financing, which increases your cash-on-cash return and essentially, how hard your money can work for you.

Take this for an example: You buy a property for $500,000 and put $150,000 down on a mortgage, plus pay $15,000 in closing costs, for a total of $165,000. After rents come in and expenses are paid, you have a cash flow of $36,000 annually. Your return on the cash invested is nearly 22% annually. If you have other available cash, that mortgage leverage allows you to invest in a second property or another opportunity, helping grow your wealth faster and diversify your holdings.

Financing isn’t guaranteed, however, and how easy or difficult it is to obtain fluctuates with the economic climate. If you can or are willing to occupy your property as your residence or the home for your business, you can capitalize on better financing terms that include less money down, better interest rates, and longer amortization terms.

The following is a guide to the different types of commercial real estate loans that are possible, whether you are buying a multifamily, retail, office, industrial building, or land.

Conventional investment property loans

If you are buying a multifamily, retail, office, single-family home, or industrial property as an investment with a conventional loan, you are generally expected to put 20%–30% cash in as a down payment, depending on the lender. Conventional essentially means with no special considerations or backing from a federal government agency such as the Federal Housing Administration, Veterans Affairs, or the U.S. Department of Agriculture.

Unlike when you’re buying a primary residence, banks primarily use the income from the investment property as their biggest barometer for whether to make the loan, but you will be asked to make a personal guaranty, and they will evaluate your personal finances as such. A personal guaranty means you are personally responsible to pay the note, even if you used an entity or corporation to purchase the property (and that entity is the holder of the note).

Conventional commercial loans are typically shorter-term notes than residential mortgage rates with fluctuating interest rates. For example, you may obtain a conventional commercial loan at 5.5% for three years, after which it will balloon, which means you technically need to pay it off or refinance out of it. As long as things are going well, the bank will agree to continue to hold the mortgage but will reset the interest rate at that time to the current rates.

While residential mortgages are often amortized over 30 years, commercial ones are usually no longer than 25 years, and most commonly around 20 years. How long a bank is willing to amortize depends largely on its policies and the attractiveness of the deal, and your relationship with the bank.

FHA Section 207 multifamily loans

FHA will back the purchase or refinance multifamily properties with five units or more if they meet certain qualifications, such as:

  • Each unit has a complete kitchen and bath.
  • The property has undergone a major rehabilitation within a minimum of three years prior to the mortgage application date (it allows you to complete non-critical repairs within a year of closing on the loan).

This program can be great because it will offer loan amounts higher than a conventional loan will and at higher loan terms with fixed rates (up to 35 years), and applies to for-profit and nonprofit borrowers as well. For market-rate apartment buildings, FHA will lend 83.3% of the value, and up to 90% for certain other projects, such as projects that meet the HUD definition of affordable housing, and Section 202, which is housing for low-income elderly people.

To get started with the program, you have to get in touch with a HUD center near the property location.

FHA Section 221 multifamily loans

This type of loan allows for the new construction or substantial rehabilitation of apartments primarily for the disabled, elderly, and moderate-income families. The terms are for up to 40 years by HUD-approved lenders.

The project has to contain five or more units but can be detached (such as homes all part of the same community on the same street), apartments, semi-detached, or co-ops.

FHA Section 220 multifamily loans

If you’re looking at acquiring an apartment building in one of HUD’s urban renewal, code enforcement, or revitalization areas, you can get the FHA Section 220 loan to construct or rehab it. The project must consist of two or more units, and the maximum loan amount is 90% of the cost of repair and rehabilitation and the value of the property before the rehab.

Like Section 221, the maximum loan term is the lesser of 40 years or 75% of the economic life of the project.

To determine eligibility for this program, you can look up the census tract for your prospective property and cross-reference it with HUD’s revitalization areas list.

Peer-to-peer or private investment property loans

Some property transactions, such as fix-and-flips or other distressed properties, are difficult to finance through traditional banks because they are inherently risky. That is where peer-to-peer, private, or hard money lenders can be a good resource for financing commercial real estate investments.

Private lenders often charge higher origination fees and interest rates, depending on the borrower’s experience level and how promising the deal is. Private loans are often for shorter terms, such as three years or less, but are amortized as 25 or 30 years, just like with a traditional bank. If the property needs work, you can use a private money loan to fund the development and construction and refinance it into a conventional loan later, once the asset is stabilized and less risky in the traditional bank’s eyes.

Owner-occupied financing

You can receive favorable financing terms if you plan to live or occupy your business in your commercial real estate property.

The best thing about this scenario is its ability to get your foot in the door in the real estate investing industry with less cash, before using your cash flow to move into the next property, and the next one.

Even if you sold the first owner-occupied property, you can keep the property’s financing and obtain owner-occupied financing for the next one too. Ask your bank about what their specific timeframe requirements may be for owner-occupied deals. You may have to agree to occupy for three years or more.

Apartments

If you’re hoping to get started by owning a multifamily or apartment building, you could live in one of up to four units to get FHA owner-occupied financing.

These loans have low interest rates and require you to put down as little as 3%. The rate limits vary, but are just over $725,000 in expensive markets. You can even use most of the rental income from the other units to help you qualify for the loan. The FHA requirements and process allows people with lower credit scores or dings on their credit to obtain loans, so it may be a good program for those just getting their feet wet in real estate investing. The minimum credit score to qualify to put 3.5% down is 580. Anything between 500 and 579 requires 10% down.

You’ll need to pay a mortgage insurance premium upfront, which is 1.75% of the loan amount paid at closing. It can be financed. Then there’s an annual mortgage insurance premium ranging anywhere from about a half point to one point, depending on whether your loan term is 15 or 30 years. To cancel them or stop paying the premiums, you’ll have to refinance or sell your home.

FHA has a 203(k) loan program that allows owner-occupants to renovate the property with bank funds. A limited version of the program allows improvements of $35,000 or less, while the standard program is a little more onerous of an application process but the property total must still fall within the FHA mortgage limit for your purchase area.

Find an approved FHA lender on HUD.gov.

VA loans

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VA loans can also be used for owner-occupants to live in one of up to four-unit buildings, but borrowers must qualify for a certificate of eligibility by the VA, which usually requires a certain number of days or years in active service. These loans do not require any money down, and do not require any mortgage insurance. This is perhaps the biggest benefit of a VA loan.

However, the VA charges a one-time loan funding fee of 1.25–3.3%, depending on whether you are electing to put any money down and whether it’s the first or second time using the VA loan. This can be wrapped into the loan. There’s also no minimum credit score requirement for VA loans.

Even if you move out of the property later and rent it out as an investment property, you can keep your VA financing.

Conventional owner-occupied for retail, office, industrial

If you occupy at least 50% of leasable space in a commercial property with your own business, as long as your business’ cash flow can service the debt, you can get a conventional loan with premium rates.

SBA 504 loan

One little known vehicle for owner-occupied commercial properties is the Small Business Adminstration’s 504 Loan program, which gives small businesses with long-term, fixed-rate financing for acquisition and renovation, and even equipment and soft costs like architect fees.

The 504 business loans are made through local Certified Development Companies, or CDCs, which help evaluate the impact the loan will have on meeting the area’s goals and business development objectives. The way it works is that the SBA provides 40% of project costs, while a traditional bank provides 50%, and the borrower contributes 10% down. There are no balloon payments or terms like there is in conventional commercial financing.

Businesses with a net worth under $15 million and average net income of $5 million or less after federal income taxes for the immediate two years prior to the application are eligible for the 504 loan. The maximum loan amount is $5 million, and the SBA usually stipulates a business must "create or retain one job for every $65,000 guaranteed by the SBA."

The borrower also has to make personal guarantees and the interest rate terms are five to 10 years.

Conventional lot loans

Financing for land is the trickiest of all, because it is the most speculative. Many conventional lenders, if they lend on land at all, will only finance up to 50% of the cost.

Construction lenders or banks that specialize in land development may allow you to finance 75% of the cost, and you may be able to wrap in planned construction costs (such as to build a single-family or multifamily structure).

Private lenders may also be able to fund a raw land development loan.

Shop around

Just like with any service, you’ll want to shop around in order to get the best rates and the best deal on your commercial real estate mortgage loan. If you’re flexible about your property’s use, there will be many more loan options at your disposal, some with incredible terms that can substantially boost your profits over the long term.

Your ability to make a lender say yes and compete for your business can save you potentially thousands of dollars annually in your interest rate and fees. Do this by crafting a compelling proposal and business plan for your property to present, and have your personal finances and paperwork in order to allow for a smooth transaction.

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