What is a commercial real estate loan?

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Whether you’re a subdivision developer embarking on a new project or an office building owner looking to refinance, chances are you’ll need a commercial real estate loan. Commercial real estate loans work differently than residential mortgages in terms of underwriting, structure, interest rates and fees, and there are several types to choose from. Here is a guide.

What is a commercial real estate loan?

A commercial real estate loan is typically used to purchase, construct, rehabilitate or refinance commercial, industrial and other non-owner-occupied property. That can include an office building, multi-unit rental building, medical facility, warehouse, hotel or vacant land on which to build one or more of these types of properties. Commercial mortgages can also be used to buy and develop land on which single- or multi-family homes will be constructed and sold.

Commercial real estate loans are secured by commercial property. Unlike a residential mortgage, the underlying asset is not a primary residence. Instead, the commercial lender underwrites the income — such as rent from tenants — and expenses that the property will generate.

“Ideal candidates to pursue a commercial real estate loan include borrowers who either own the property and are seeking to lower their interest rate by refinancing or seek to obtain capital through a cash-out refinance,” explains Chris Moreno, CEO of GoKapital, Inc., based in Miami. “Also, investors who are interested in working with commercial properties and diversifying their portfolio should explore this type of loan option. Furthermore, business owners who rent a location and qualify for a commercial real estate loan may be better off obtaining financing to purchase their business property.”

Commercial real estate loan types

There are several different kinds of commercial real estate loans to choose from:

  • Conventional commercial real estate loan, offered by banks and other lenders, with terms ranging from five to 30 years, interest rates as low as 3.5 percent and a minimum down payment of up to 20 percent
  • Commercial bridge loan, offered by various lenders, as a means to bridge the financing gap until longer-term financing is found; terms usually span up to two years, with only a 10 percent to 20 percent down payment often required
  • SBA 7(a) loan for up to $5 million over a max term of 25 years
  • SBA 504 loan, comprising both a Certified Development Company (CDC) loan portion for up to 40 percent of the loan plus a bank loan for up to 50 percent of the loan that collectively can max out at $5 million
  • CMBS or conduit loan, part of a pool of commercial real estate loans (a commercial mortgage-backed security, or CMBS) sold on the secondary market; most conduit lenders finance a max of $3 million, and terms usually span five to 10 years with an amortization of 20 to 30 years
  • Hard money loan, which works like a bridge loan but is typically offered by a private lender

“If you’re looking to close on a transaction quickly or have less-than-perfect credit, you’ll probably have to work with a private lender,” Moreno says.

Commercial real estate loans are also categorized by asset classes. These include apartment buildings, office buildings, medical buildings, industrial buildings and multi-unit versus single-tenant assets.

“All of these are evaluated differently by the lender,” explains Barry Saywitz, president of The Saywitz Company, a commercial real estate brokerage based in Newport Beach, California. “The value of the asset will be determined by the appraisal required, and the appraisal will be determined based on the quality of the tenant, their credit, payment history and rental rate, and the condition of the building and expenses involved.”

Commercial vs. residential loan

Like a residential mortgage, a commercial mortgage can be used to purchase or refinance a property. Commercial real estate loans, however, typically come with a shorter term than a residential mortgage loan. A commercial loan could have fixed rate for five years and a 15-year term, amortized over 20 years, for example, explains James Sandagato, vice president and commercial team leader with Cornerstone Bank in Worcester, Massachusetts.

“The interest rate would adjust every five years, and the balance would be due at the end of the 15-year term, which is referred to as a balloon note,” Sandagato says. “The balance could then be repaid at the end of the term, or the loan can be renewed on rates, terms and conditions to be determined at that time.”

By contrast, most residential mortgages come with fixed interest rates and are usually repaid over 15, 20 or 30 years.

Commercial loan lenders also look to the property, not the borrower, as the source of debt repayment.

“With a residential loan, the lender underwrites the repayment capacity of the borrower by analyzing his or her income and creditworthiness,” says Suzanne Hollander, a real estate attorney and professor at Miami-based Florida International University. “A commercial loan lender looks at the debt service coverage ratio from the income the property will generate.”

In addition, the fees and closing costs involved with a commercial real estate loan are commonly much higher than those for a residential mortgage, along with the down payment. Count on making a down payment of at least 20 percent, although up to 45 percent could be required.

The appraisal process is different, as well, Saywitz says. A commercial real estate appraiser will review the property’s potential rental income, comparable sales and prospective replacement costs. This generally takes longer than a residential appraisal that often merely examines comparable sales in the area.

When it comes to interest rates, expect to pay more for a commercial mortgage, too.

“Conventional lenders will typically offer rates today ranging from 3.5 percent to 5 percent and require a credit score of at least 680 for conventional commercial financing,” Moreno says. “Private lenders, on the other hand, generally offer rates from 7 percent to 12 percent.”

How to get a commercial real estate loan

The process of pursuing and applying for financing for a commercial property involves several steps.

  1. Assess the commercial property’s financials carefully. “Lenders will not only review your personal credit history and financials, but they will also evaluate the underlying asset thoroughly,” Moreno says.
  2. Determine the type of commercial loan you need and shop around. If you have a strong credit profile and your financials are in good shape, you should be able to work with a bank.
  3. Complete a commercial real estate loan application. You’ll need to provide documentation such as three years’ worth of personal and business tax returns, a personal financial statement, personal balance sheet and historical income and expenses for the property. “[This] can also include the property seller’s Schedule E from their federal tax return or a financial statement prepared by the seller,” Sandagato says. Also, be ready to furnish a current listing of each tenant, the space they occupy, tenancy commencement dates, lease details and lease agreements.
  4. Await the loan processing and underwriting. The lender will use the information you provide to substantiate the property’s ability to repay the debt. “In general, lenders are looking for the property to be able to support a debt service coverage ratio of 1.2 to 1,” Sandagato says. “What that means is, for every $1 in mortgage debt on an annual basis, there is $1.20 in cash flow to support it.”
  5. Close on the loan. Closing a commercial loan can often take longer than it would for a residential mortgage. “Remember that the lender views a loan to purchase commercial property as more risky than residential, so they need to do their due diligence,” Hollander says.

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