The Investor's Guide to Acquiring a Loan for Commercial Investment Property

Commercial real estate investing represents a massive wealth-building opportunity, but only if you can nail down the proper financing. Whether you're eyeing an office complex, retail center, or multi-family property, you'll need to know about commercial loan options and the overall process in order to set yourself up for success.

This article covers commercial lending details, such as loan types and eligibility criteria, for real estate investors seeking the potential of commercial investments. We'll also discuss the differences between commercial and residential mortgages, as well as each step of securing a loan for your business.

From evaluating lenders and investment strategies to compiling the required documentation, you'll learn what lenders need to approve a loan for your property. Knowing key factors like debt service coverage, down payment requirements, and loan-to-value ratios can increase your chances of approval.

With the right preparation, you can increase your chances of obtaining a commercial loan that sets you up for success in the competitive real estate market.

Understanding the commercial real estate loan

A commercial real estate loan is the doorway to owning large income-producing properties beyond single-family homes. Rental property investors use these loans to buy, build, rehab, or refinance income-generating assets.

Selecting the right loan type is key based on your investment strategy and timeline. If you plan to buy, renovate, and flip a property quickly, you'll need different terms than if you planned to hold your property long-term. Thus, aligning your loan with your profit strategy enhances flexibility and boosts potential returns.

Types of commercial real estate loans

Once you have established your investment strategy, you'll have several kinds of commercial real estate loans to choose from, each designed to meet the different needs of different borrowers. Here are the loan types you can expect to see:

Conventional loan

Banks, credit unions, and other traditional lenders provide conventional commercial loans. Government programs do not back these loans, and they tend to have higher down payment requirements and stricter criteria. 

Real estate investors might use this loan type to refinance an existing property once it's stabilized and has strong financials.

Commercial bridge loan

Also known as a swing loan or gap financing, commercial bridge loans are a short-term financing option that can help you bridge the gap between buying a property and getting permanent long-term financing. These loans have shorter repayment periods, usually within a year or less, and have higher interest rates.

This loan type can prove beneficial if you're buying a property that needs upgrades and rent increases before it generates income and can qualify for a conventional loan.

Conduit loan

Conduit loans are a type of commercial mortgage-backed security (CMBS) that is pooled and sold to investors on the secondary market. These loans are usually non-recourse, meaning the lender's recourse is limited to the property itself. This limits the lender's ability to go after the borrower personally if the investment property fails to perform as expected.

You can use this commercial loan for all types of real estate properties that generate income.

SBA Loan

The Small Business Administration (SBA) allows business owners to use their loan programs to purchase commercial real estate properties like office buildings, retail spaces, hotels, and medical offices. The key requirement of small business loans is that the business must occupy and use a majority of the property for its own operations.

You can't use this loan to rent out an investment property, such as an apartment complex, that you would not occupy as a business. The business itself has to be the main occupant and user of the commercial real estate purchased with an SBA loan. There are two types of SBA loans:

• SBA 7(a) loans: This is the most common type of SBA loan and can be used to purchase or refinance real estate as part of a broader business purpose. SBA 7(a) loans are flexible and can cover various other business expenses alongside real estate, such as working capital or equipment purchases.
• CDC/504 loans: Certified Development Companies (CDCs), nonprofit intermediaries, provide CDC/504 loans specifically tailored for major fixed asset purchases like real estate. They work with the SBA and private-sector lenders to provide financing.

Hard money loan

Hard money loans are short-term funding options provided by private lenders or investors. They're often used for fix-and-flip projects or as a bridge until permanent financing is available. They tend to have higher interest rates and more stringent terms.

Investors might use this loan type to move quickly on getting a property under contract with plans to renovate the property and secure more long-term financing in the future.

How commercial loans compare to residential loans

If you're used to residential loans, you'll need to familiarize yourself with several of the key differences with commercial real estate financing in order to approach your lender with confidence:

Eligibility

Lenders are stricter with commercial loans, so to get approved, you'll need to show:

• Strong finances: They'll review your financial statements and credit history.
• Proven experience: You must show a solid track record in successfully managing commercial properties.
• Viable property: Lenders will evaluate the property itself for its income potential, market value, occupancy rates, rental income, and overall condition.

Loan repayment schedules

Commercial loans have much shorter repayment periods compared to residential mortgages. While residential mortgages usually span from 15 to 30 years, commercial loans often have 5 to 20 years. 

This shorter timeframe means you'll need to make higher monthly payments or potentially face a balloon payment at the end of the term.

A balloon payment is a large lump sum that covers the remaining balance on the loan at the end of the term, and this can be substantial. If you're not able to secure refinancing or come up with the cash to cover the balloon payment, you could risk losing the property.

Loan-to-value (LTV) ratios

This ratio compares the loan amount to the value of the property. For commercial loans, lenders require a lower loan-to-value ratio.

This means you'll need a much larger down payment compared to a residential mortgage. Generally, commercial loan down payments can range from 20% to 40% of the property value.

In contrast, some residential mortgages, such as FHA loans, may only require 3% to 5% down.

Risk considerations

Commercial properties are generally considered higher risk investments than residential properties because they're more likely to be affected by economic fluctuations, impacting their vacancy rates.

If the local economy takes a downturn, businesses may start closing or downsizing, which could lead to higher vacancy rates in commercial properties. This increased risk is why lenders have stricter lending criteria to protect themselves.

Interest rates and fees

Commercial real estate loans usually have higher interest rates and fees than residential loans. These can either come in the form of one-time upfront fees or recurring annual fees.

One-time fees may include:

• Appraisal fee
• Legal fees
• Application fee
• Origination fee, typically 1-2% of the loan amount
• Survey fee

Recurring annual fees can include:

• Loan servicing fee, usually around 0.25-0.5% of the loan amount

For example, if you get a $5 million loan for an office building, you might pay a 1.5% ($75,000) origination fee upfront. Then, every year until you pay off the loan, you'd pay a 0.35% ($17,500) annual fee in addition to the interest charges.

Loan prepayment restrictions

Commercial real estate loans often have restrictions on prepayment or paying off the loan early before the end of the loan term. To protect their expected returns, lenders use the following prepayment penalties:

• Prepayment penalty: This is the most common form of prepayment penalty. Calculate it by multiplying the remaining loan balance by the percentage rate specified in the loan terms.
  For example, if you have a $1 million loan with a 2% prepayment penalty rate and you still owe $800,000, the penalty would be $16,000 (2% of $800,000).
• Interest guarantee: With this type of penalty, the lender wants to make sure that they still get a minimum amount of interest earned, so they set a guaranteed interest rate and time period, even if you pay the loan off earlier than expected.
  Suppose your commercial loan has an 8% interest rate guarantee for the first 48 months. If you decide to prepay the loan during that period, you'd still have to pay the lender the interest they would have earned for those 48 months. Aside from that, there can also be a separate exit fee that you'd have to pay.
• Lockout: This completely restricts you from paying off the loan early for a set time period, usually the first few years of the loan. During the lockout, you cannot prepay or pay off the loan at all, no matter how much you might want to. The lender uses this to make sure that they receive the full interest payments for that initial lockout period before allowing any early payoff.
• Defeasance: With defeasance, instead of paying cash to the lender to prepay the loan, you replace the original loan collateral, property, or asset that secures the loan with alternative collateral — typically these are government securities like U.S. Treasury bonds. This can reduce the fees you'd have to pay compared to other prepayment options; however, you may face penalties and costs related to the defeasance process itself.

Weighing the benefits against the drawbacks of commercial loans

When considering taking out a commercial real estate loan, make sure to first evaluate the following:

Benefits

• High lending limits: Commercial real estate loans have higher lending limits than residential home loans, allowing you to finance bigger projects.
• Fast closing process: Depending on the lender and the complexity of the deal, commercial loans can be approved or closed quickly. This allows real estate investors to capitalize on investment opportunities more quickly.
• Multiple options: You can use a variety of investment property loans to buy commercial real estate. Not every loan will be a fit for your situation, but you have several different routes you can evaluate as part of your strategy.

Drawbacks

• Large down payments: A commercial loan requires a large down payment, which is a hefty upfront cost.
• Higher interest rates: Commercial property loans have higher interest rates than residential home loans because lenders consider them riskier investments.
• Personal financial risks: For many commercial loans, you have to personally guarantee the loan. This means your personal assets, like your home or savings, could be at risk if the investment doesn't perform as expected.

Getting a commercial loan

Ready to apply for a commercial loan? Here's a step-by-step guide on how to do so:

1. Investment strategy

Before applying for a commercial real estate loan, you need to know:

• How much money you need to borrow.
• Whether you're buying a property, renovating, or refinancing.
• How much time you'll need to pay the loan back based on expected rental income.
• If you have any property or assets to use as collateral for the loan.
• Your current financial situation, like income, savings, and credit score.

2. Application entity

Will you apply as an individual or business? Business entities include LLCs, partnerships, and corporations. If you file with one of these entity types, the lender will seek details about the business's finances and history. It's generally easier to apply as an individual, but this also means that you're personally on the hook for the repayment of the loan.

3. Organize finances

Because commercial lenders have much stricter requirements compared to home loans, you'll need to organize and improve your personal and business finances. To do so:

• Fix any past bankruptcies, tax issues, or late payments on debts.
• Calculate your debt-service coverage ratio (DSCR) by dividing the rental income by the proposed loan payment. Show that your rental income can cover the new loan payment by at least 1.25 times.
• Improve your personal and business credit scores to 680 or higher if needed.
• Have the last 2 years of tax returns and financial statements ready.

4. Evaluate lenders

As tempting and convenient it may be, don't just go with the first loan offer you get — loans are a long-term commitment! Since you'll likely have this commercial loan for 5 to 10+ years, make sure to compare the offerings of multiple lenders. Here's what you should look for:

• The specific type of rental property loan they offer for your situation.
• Their current interest rates and any upfront fees.
• Repayment details like interest-only periods, full loan repayment timelines, and balloon payments.
• The minimum requirements they ask for, such as credit score, income, and down payment.
• Whether they charge penalties for paying the loan off early.
• Their experience and expertise with rental property loans.

5. Prepare required documents

Once you've narrowed down your lender options, start gathering all the documentation and paperwork they'll require for approval. This typically includes:

Property documents

Lenders require these to evaluate the value and condition of the commercial property you plan to purchase.

• Current rent rolls, income statements, and leases for the rental property.
• A recent professional appraisal of the property.
• Title and deed info and any existing mortgages.
• Proof of commercial property insurance.

Income documents

For approval, you'll need documented income sources that can cover the new loan's debt service. The lender wants to see stable, sufficient cash flow, whether the borrower is a person, LLC, or corporation.

• Personal and business tax returns for the last 2 years.
• Recent bank statements.
• Profit and loss statements for your business.

Business documents

The lender will want to evaluate the business's overall health and viability, as well as the experience and qualifications of the management team. Key documents can include:

• Articles of incorporation or organization (for corporations or LLCs).
• Business plan and financial projections.
• Resumes or bios of key management personnel.
• Franchise agreement (such as a franchised hotel purchase).

6. Apply for the loan

Once you have clear investment goals, your finances in order, and all the required documents ready, you can officially start applying with the top lenders you've shortlisted. Be prepared for an in-depth review process:

• The lender will verify all the information you give about your finances and the property details.
• You may need to provide some additional documents or clarification if requested.
• The full loan processing and approval can take 30-90 days or more in some cases.

If approved, you'll get a loan estimate outlining the final loan terms, interest rate, fees, and closing costs.

How to get a commercial loan for rental property, explained

Securing a commercial real estate loan takes effort, but with the right knowledge and strategies, you're setting yourself up for success. Throughout this guide, we've explored the various options, eligibility requirements, and details that lenders consider.

Getting a commercial loan requires more than just the right numbers and documents — lenders want to see that you have the industry expertise and business acumen to operate a profitable commercial business, which calls for anticipating their concerns regarding your capabilities and experience. Present a compelling case that highlights how you'll run a viable, money-making operation with their financing.

Investing in commercial real estate is a long-term commitment, and the right financing can make all the difference in achieving your investment goals. Take the time to research your options and make a decision that aligns with your financial situation and investment plans.

Commercial loan for rental property FAQs

Are commercial loans hard to get?

Yes, commercial loans can be harder to get than residential home loans. Lenders have stricter requirements and expect substantial collateral from borrowers. But if you have a solid business plan, good credit, and the property can generate enough income, you'll have a higher chance of approval.

Is commercial lending lucrative?

Commercial lending can be lucrative for lenders since commercial real estate loans tend to have higher interest rates and loan amounts compared to residential mortgages. The risks are also higher, so lenders scrutinize borrowers' finances, experience, and property details before approval.

What kind of loan is based on rental income?

A loan based on projected rental income is called a DSCR (debt service coverage ratio) loan. Lenders underwrite DSCR loans based on the property's ability to produce enough rental income to cover the new loan's debt payments.