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Get PreApproved by our Exclusive Commercial Lending Partner: CommercialDirect
If you’re ready to make the leap to commercial real estate, you’re poised to make great money. That is, if you know what you’re doing. In our continuing series, we examine the basics of buying commercial real estate, along with tips for the process.
Getting a commercial real estate mortgage is the same as a residential mortgage. Not necessarily simple, but not more complex either. Right?
That’s the main misconception of commercial mortgages, and a major error that people make when they consider buying commercial real estate. Let’s take a look at this and other mistakes that new commercial buyers can make:
- Misunderstanding Mortgages. Commercial and residential mortgages are similar in some ways, but there are many important distinctions. Commercial mortgages require significantly more documentation, in terms of financial records and business records, that can go back over many years. They require a higher up-front payment. While 100 percent financing is possible for residential loans, business and commercial properties don’t have that option. Finally, the application and approval process takes much longer than residential loans, as they require greater due diligence on the part of the lender and an exhaustive appraisal process.
- Coasting on Credit. While high credit ratings can help you in obtaining a great residential mortgage deal, commercial mortgages are much more complex. You must prove through documentation that you have a steady, positive cash flow to get approved.
- Forgetting about Foreclosure. In residential properties, as long as you make regular monthly payments, you’re safe. With commercial mortgages, lenders have the right to ask for financial convenants, updated documentation on your financial health. If cash flow may fluctuate, the lender could theoreticlly foreclose to prevent you defaulting on the mortgage. Every lender is different, so asking about financial convenants is key.
- Resting on Rent. Many potential property owners believe it will be easy to find tenants, whether for apartment or office buildings. Don’t make the mistake of having open leases, and missing out on rental income you need to pay your mortgage.
Now that the misinformation is cleared, what is the truth about commercial mortgages? How realistic is a commercial mortgage for you?
- Affordability: Lenders look at two key ratios to determine if you can make the consistent mortgage payments you need. The loan-to-value ratio (LTV) is your desired loan amount divided by the appraised property value. If you wish to borrow 75 percent of the property value, your LTV is 0.75. The lower the ratio, the better candidate you are for lower interest rates. Debt service coverage ratio (DSCR) says that your property will provide more income than you need to make monthly mortgage payments. Lenders determine your DSCR by dividing your net income by your monthly interest and mortgage payments. Your DSCR needs to be at least 1.25 or higher to be considered at low risk for a loan.
- Getting Started: Typical commercial real estate mortgages start at $400,000 or more. Commercial lenders generally require 20% to 30% down payments. The typical term is 15 to 20 years. Lenders will analyze the ratios above and your finances to see if you can cope with these costs. You yourself will need to keep in mind the additional costs of day-to-day facility operating expenses such as employee payroll, utilities, supplies, and marketing.
Continue reading our commercial real estate series to learn about commercial mortgage types and costs, and the process for obtaining a commercial mortgage.
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