What Is Real Estate Financing?
Real estate financing is the use of a term loan, commercial real estate loan, SBA loan, or some other financial agreement to secure the property for a business.
There are a couple of situations where you might need real estate financing. The first is if you would rather purchase your business office or store, rather than leasing a space. The other is if you run a real estate investment business. While both are technically real estate financing, a loan for a single commercial property that will be utilized for business purposes is very different from an investment property.
Real Estate Financing for Resale
If you are creating a business flipping houses, you should know that you may not qualify for some traditional mortgage loans. Most conventional mortgages available through banks are designed for home buyers and are backed by the FNMA (Fannie Mae). To qualify for these loans, you typically need to live in the home for at least a year. If you are trying to flip homes quickly to avoid property taxes and mortgage payments, a conventional mortgage will probably not work for you.
Another key to successful real estate investing is to eventually start accumulating enough business savings to pay for new real estate investments in cash. Every time you take out a loan, you will face origination, appraisal, underwriting, private mortgage insurance and other fees, which chip away at your profits. Furthermore, many properties that are best for “house flipping” are nearly condemned homes, which are unlikely to appraise.
In short, you can use real estate financing to get your home renovation business off the ground, but should eventually shift to funding your real estate investments with profits from other sales.
Real Estate Financing for Rental Property
Real estate financing for a rental property is often easier to tackle than financing a house to flip. Many new real estate investors opt to get a conventional mortgage and live on site for a year or two, along with their renters. However, as your business grows, you won’t be able to live in every house and may need to consider other options, including commercial real estate financing or purchasing properties with cash.
Commercial Real Estate Financing
If you are looking to finance a commercial property, there are options for commercial mortgages or other business loans. Often, acquiring or renovating a business space is a big step forward for small businesses, as real estate presents a major business asset.
Before deciding to purchase a commercial property, consider whether you would like your business to be in that location long-term and if you feel comfortable with the resale value in the neighborhood. Just like homebuyers, you will be 100% responsible for your property, including property taxes, utilities, and repairs, which may be covered in your current commercial lease.
If a commercial real estate loan is right for your business, here’s what you need to know about getting a loan.
Types of Real Estate Financing
If you were to go to a bank and apply for a regular business loan, you would be applying for a term loan. A term loan is simply a type of loan that is set to be paid off within a specific period of time with a consistent repayment amount. Funds from regular business loans can be used for a wide variety of business expenses, including buying real estate or renovating an existing property. You can get a term loan as a bank loan or online through a private lender.
Commercial Real Estate Financing & Loans
Commercial real estate loans are meant for business owners and franchisees, and can only be used to finance new commercial space or renovations. There are two main types of commercial loans: interest rate reset loans and balloon payment loans. With an interest rate reset loan, your loan will have a fixed interest rate for the first few years, but will then begin to vary according to the market afterward. Interest rate reset loans tend to have longer terms than balloon payment loans. A balloon payment loan has shorter terms and lower monthly payments, but once the end of the term arrives, the borrower will need to pay the outstanding balance of the loan.
SBA Loans for Commercial Real Estate
If you are a small business owner, some types of SBA loans can be used for purchasing real estate. CDC/504 loans are specifically intended for major, long-term investments like purchasing commercial real estate or constructing a new building for your business. SBA 7(a) loans are available in amounts up to $5 million and can be used for many different business expenses, including buying commercial real estate or renovating an existing property.
Pros and Cons of Real Estate Financing
Pros of Real Estate Financing
Since the property itself can serve as collateral, business owners often don’t need to provide anything else to secure a loan as they would for a cash loan from a bank. However, some business owners may need to provide a personal guarantee for the loan or an extra asset for collateral if the lender is concerned about the business’s credit score. Real estate financing can have a lower interest rate than a traditional loan because the real estate protects the lender’s investment. You can use a commercial mortgage broker to find the best financing at the lowest interest rate for your real estate deal.
Another perk of owning property is the possibility of a home equity line of credit (HELOC). After you have paid down your mortgage, you can sometimes take out a loan called a HELOC, or a home equity loan, secured by the gap between the value of a piece of property and the amount you owe on the mortgage. Since HELOCs are a secured loan, you can avoid some of the higher interest rates of other loans down the road. It is important to note that a HELOC may not be an option if you are not using at least part of the property as your primary residence.
Cons of Real Estate Financing
One of the cons of real estate financing for businesses is that many of the residential loans enjoyed by homeowners are not available to businesses. For example, businesses cannot use a loan from the United States Federal Housing Administration (FHA loan) for purely commercial properties. Instead, business owners are restricted to specific commercial lending procedures.
Another hurdle to real estate financing could arise if you’re looking for a loan to purchase a property where you would lease some or all of the space out to other businesses. In some cases, you might not be eligible for some types of real estate financing. For example, CDC/504 loans backed by the SBA are only available to businesses that will be occupying at least 51% of a given property.
Additionally, commercial real estate loans often have restrictions against prepayment. If you choose a type of real estate loan that has shorter terms, you’ll most likely have to make a very large balloon payment at the end of the term. If you aren’t able to pay the full amount of the balloon payment at the end of the term, you may need to take out another loan to pay the balance, which is something many business owners may not be comfortable with. Generally, real estate financing for commercial purposes is something to consider carefully, and something you must prepare your business for before acting on.
Applying for Real Estate Financing
Since real estate is such a large investment, applying for a real estate loan is a more complicated process than applying for a short-term loan. Since you’re interested in a property to be used to generate income, lenders are going to be very interested in seeing a detailed business plan.
The exact information you’ll need to provide on the loan application will depend on how you plan on using the property (example: if your business will be occupying the entire space or if you’re buying a property for the purpose of leasing it out to other businesses). However, you can expect to provide much of the same information that you would need to provide for any other type of business loan, such as:
- Resumes for yourself and your partners or other principal employees
- Copies of business and personal tax returns
- Lists of individual debts and assets
- Income projections for the next 3-5 years
Since you are dealing with real estate, you will need to pay for things like having the property surveyed and appraised. You may also need to have an environmental study done on the land.
Lenders will consider your loan-to-value ratio (LTV), which is related to the amount of your down payment. The LTV is the loan amount compared to the total purchase price of the property. For example, if you’re able to make a 20% down payment, that means the lender would be providing a loan for 80% of the property’s value. In many cases, lenders look for LTVs that are 80% or lower because a low down payment puts an additional risk on the lender.
Another thing lenders will consider is your debt service coverage ratio (DSCR). Your DSCR compares your annual net operating income (NOI) to your annual debts. This helps lenders gauge how much cash flow you are generating. Generally, lenders are more inclined to approve loans for businesses with a DSCR of 1.25 or higher.