The In's and Out's of Qualifying for a Commercial Loan
Over $3 trillion multifamily and commercial loans are currently outstanding in the United Sates. Commercial loans come in a variety of types varying from short term working capital, lines of credit, term loans, and commercial real estate loans. Commercial lenders include commercial banks, mutual companies, private lending institutions, hard money lenders and other financial groups. These lenders typically have widely varying standards on which they base their loan criteria and evaluate potential borrowers.
Commercial lending institutions typically look for the 3 C’s. Those are the credit of the guarantor/ borrower, commercial real estate property cash flow/business cash flow and the commercial real estate property collateral. Nearly all lenders will look at the 3 C’s (and sometimes even the 5 C’s) for income producing commercial real estate properties. Through a commercial mortgage, the borrower is usually required to assign leases/ rents of the collateralized property that provides the lender with additional security. A commercial appraisal is a large portion of the underwriting process and is utilized to derive the sales comparison, an income approach replacement cost, and the overall value of the real estate. Each lender has different credit requirements. However, there is an industry standard minimum for personal credit requirements.
A small business, one that is borrowing less than $2,000,000 will typically utilize a smaller local bank or a direct commercial lender. Whereas larger loans will be made by mega or regional banks. The list of items needed in order to qualify for a commercial loan is long, and it may be an ongoing process of documentation that one needs to supply to the lender throughout the life of the loan. Some lenders will ask for annual or quarterly income statements, tax returns or balance sheets. In addition to applying and qualifying for a loan, usually income tax returns and 3 to 5 years of financial statements are required. Other documentation may also be asked for, including corporate documents, asset statements, leases and the personal financial record of the business owner.
Commercial loans come at a higher perceived risk to the lender than that of a residential loan. As a commercial loan is not backed by a government entity, such as Fannie Mae or Freddie Mac. Commercial mortgage underwriters do conduct a high level of due diligence in order to ensure that an individual or business if fully qualified for the loan. The debt that a business carries is weighed against the cash flow of the business which for most banks want to see a minimum of 20 percent higher net income than debt carried.
The debt service coverage ratio or DSCR, is what is used in commercial real estate, this is factored by taking the net cash flow and comparing that to the mortgage debt service (principal and interest payments). The ratio aids a lender in determining how much someone can afford for a monthly commercial loan payment. The normal range for the ratio is anywhere between 1.1 and 1.4. Meaning that if a property has $125,000 in net cash flow and $100,000 in mortgage debt service annually then the debt service coverage ratio would be 1.25. The DSCR and the loan-to-value (LTV) ratio are two of the most important considerations for a lender when issuing a commercial mortgage.
Commercial rentals also have unique lending nuances as a borrower can assign an interest in leases or rents from the building. Additionally a contingency can be in place for the lender that they may take rents and profits should the borrower default on the mortgage. A commercial real estate loan also takes into account the loan-to-value ratio that ultimately helps to determine the interest rate.
If one doesn’t qualify through a traditional lending institution, then a private lender may be able to issue a loan. A hard money loan is typically utilized as a temporary means of financing due to the higher interest rate it carries. This type of loan is utilized when there isn’t enough time to obtain a traditional loan or one may not meet all of the lending requirements dictated by the underwriter. Commercial lending tends to have higher down payment amounts and more stringent lending guidelines.