Applying for a commercial mortgage can be thrilling and daunting. Moving from a lease to owning your office space is a major milestone that signifies the expectation of long-term stability of a business and validation of its financial success. It’s a big deal.
To smooth the path for new borrowers, we’ve compiled a few tips on what to expect from conventional financing.
Although some of the steps will be familiar to homeowners, most of the process is quite unique to business banking.
It’s about the business, not the person
Unless it’s an investment property, homes are purchased by one or two individuals, and loan approval is largely based on personal credit history, income and a debt-to-income ratio. Commercial properties are a bit different. An owner-occupied building or condo is usually purchased as an asset owned by the business entity (such as a corporation, LLC or limited partnership), not the individual business owner(s).
If the business is not extremely strong in terms of credit history and net worth, principals of that business will be requested to provide a personal guarantee of the loan, bringing their personal financials into the business loan and making them liable if the business should default.
Terms are dictated by the amount of lender risk
Unlike residential mortgages, commercial mortgage lenders aren’t protected by government programs. Terms of a commercial mortgage loan can drastically vary from one business to another, or from one lender to another. The increased level of risk the lender takes on results in a more stringent approval process, more paperwork, and terms that are quite different than a home mortgage.
Terms of a commercial mortgage loan can be as short as three- to five-years with a large balloon payment immediately due at the end, which is very different from a home mortgage that completely repays the entire loan by the end of its term. The commercial mortgage has an amortization schedule longer than the loan repayment schedule to help keep interest low, which helps the bank manage risk. For example, a five-year commercial mortgage might have monthly payments at seven percent, followed by a balloon payment at the end for the remaining balance, versus a fifteen-year mortgage without a balloon payment at double the interest and a much higher monthly payment. Why is it more expensive? A lot can happen with a business during a fifteen year period, and the risk of loan default is much higher to the bank and reflected in the cost of the loan.
The risk of a balloon payment to the business is something to carefully consider before signing a contract. Most businesses simply refinance when the balloon payment is due, but if the business can’t qualify for the refinance and doesn’t have cash for the balloon payment, the property can end up in foreclosure.
Debt service coverage, instead of debt-to-income
The amount of monthly payment a homeowner can afford is partially based on their debt-to-income (DTI) ratio–or how much of their monthly income goes to existing debts (credit cards, auto loans, etc.) and living expenses compared to the mortgage payment–and value of the loan against value of the property (LTV). These percentages are calculated by the lender and compared against loan requirements determined by the type of loan and the lender.
In a commercial mortgage, the lender considers LTV, disposable cash and a variation of DTI called a debt service coverage ratio (DSC). This measures cash flow (net operating income) against current debt obligations to decide the maximum amount of a loan. DCRs can identify a stronger, stable property from a less creditworthy, higher risk property. Calculating DCR is generally more complex for investment properties than a fully owner-occupied property and each lender can apply nuances that influence how a ratio is defined, so a borrower should clarify exactly how a specific lender will calculate cash flow.
Look for a “right financing” banker
From LTV to ease of closing escrow, consulting with a savvy commercial banker is extremely important. Especially for first time borrowers, there can be an ocean of difference between how much you CAN borrow, versus how much you SHOULD borrow. A right financing banker will ask detailed questions to learn enough about your specific business to assist you in understanding the difference. This can be immensely important to the long-term success of a business.
Take time to ensure you’re choosing the right banker for your loan who fits your long-term needs, realizing this may or may not be the same bank handling your business checking account. This is probably the most important investment you’ll ever make for your business, and a partner who is deeply invested in your business success truly matters.