Tips for Financing Commercial Real Estate
Commercial real estate involves buying property that will be used for business purposes, such as an office, retail shop, restaurant, or industrial space, then leasing out the property to business owners and collecting rent for profit. This is an excellent way to passively generate monthly income. However, not every beginner investor has cash in the bank to buy these properties outright. In these cases, financing will be necessary. Here are a few tips to get started.
Understand Commercial vs. Residential Loans
Like residential home mortgages, commercial loans are funded by both banks and private lenders. While home mortgages range from fifteen to thirty years, a commercial loan term will generally be no longer than twenty years and may even be less than five. It also important to note that the interest rates for commercial loans are usually higher than residential loans.
Know What Lenders Want
Before you apply for a commercial real estate loan, be aware of the various factors that lenders take into consideration: the collateral you offer, your credit history, and your income tax returns and statements from the last few years. They will also pay special attention to your debt-service coverage ratio and loan-to-value ratio.
The debt-service coverage ratio (DSCR) assesses the borrower’s ability to pay back the loan. To calculate this ratio, they will divide the property’s annual net operating income by the total debt service, which includes both principal and interest. Ideally, the resulting percentage should be above 1%, as less than 1% indicates negative cash flow and an inability to pay back debt.
The loan-to-value ratio (LTV) divides the amount of the loan borrowed by the appraised value or purchase price of the commercial property. The higher the ratio, the riskier the loan is for the lender. This can impact the total cost of the loan for the investor, or it can prevent them from qualifying for a loan altogether. Conversely, a lower LTV generally aids approval and means better financing rates.
Go in Prepared
Knowing the lender will be looking at these things, it is imperative to do a few calculations of your own before you begin the financing process. As an investor, you will be responsible for property taxes, insurance, maintenance and upkeep costs, and more. Calculate your net operating income after these expenses have been deducted and know what you can afford before you ever approach the lender. Include all of this information and more in a business plan that you can use for reference.
Preparation is the key to success when it comes to financing commercial real estate. Focus on due diligence and know where you stand going into the application process.