Published March 15, 2014
Unlike most residential mortgages, which are made to the borrower, commercial loans are made to the income of the property, the quality of the property and the borrower. As a consequence, most lenders perceive a greater risk for commercial loans than residential loans, and interest rates will tend to be about a point higher than on a comparable home loan. Ever since the Great Recession, banks have been even harder on prospective borrowers seeking commercial loans, scrutinizing every detail of their businesses and other investment properties. Worried about whether you will be able to qualify? Don’t be. Just remember the 3 Cs – credit, capacity to repay, and collateral – and you’ll be just fine.
Most commercial loans are made by federally regulated banks, and the regulators require good credit. A credit score of 680 is usually the minimum, while a score of 720 or more is ideal. If your score falls to the 650 to 679 range, don’t despair, there are still lenders that will allow you to explain derogatory items on your credit report. If your explanation makes sense, they will allow a lower credit score. For scores lower than 650, there are always hard-money commercial mortgage companies out there who are willing to make riskier bridge loans. These are given at a much higher rate, but usually do not have prepayment penalties, thus giving you time to improve your credit and refinance.
One of the most important factors a bank considers when underwriting a commercial borrower’s capacity to repay is the cash flow of the property. The commercial mortgage payment must be exceeded by the commercial property’s net operating income (NOI) by a factor of at least 25 to 45 percent. This is called a debt-service coverage ratio, or DCR. Many national lenders, such as conduit lenders, also known as CMBS (commercial mortgage-backed security lenders), require that the debt-yield ratio exceed 9 to 10 percent. A debt-yield ratio is the annual NOI divided by the annual loan payments x 100. In addition to this, banks will typically give a term less than 30 years when the mortgage is due and payable. What this means is that the borrower will pay interest and principal on a 20- to 30-year amortization at the stated interest rate for the first years (in most cases 3, 5, 7 or 10 years), then repay the entire balance in one balloon payment when the term of the loan is up. This is not as dangerous to the borrower as it might seem, because property values almost always increase over the term, and principal balances go down.
Lastly, the condition of the commercial property is very important to the lender. Does the property have a lot of deferred maintenance? Is it in a good neighborhood or location? If a multi-use property (multiple tenants), are they good-quality tenants with enough time remaining on their leases? Is the property located in a larger metropolitan area? Is there adequate parking? These are all questions that pertain to the quality of the property.
By Terry Painter, President