Understanding Commercial Real Estate Financing: A Complete Guide

Investing in commercial real estate (CRE) almost always involves financing. After all, many buildings cost millions—enough that few buyers pay with cash only.

But how does CRE financing work? And how do you qualify for CRE loans? Read on to find out!

What is CRE Financing? 

Commercial real estate (CRE) financing refers to funding the acquisition, construction, or rehab of income-producing real estate. It can also mean refinancing property you already own. 

Unlike traditional residential mortgages, however, CRE financing is geared toward investors, business owners, and builders. Not your typical homebuyer.

Ways to Finance CRE Developments

While CRE financing often means debt financing, it can also refer to equity financing.

• Equity financing is when outside investors contribute capital to a project in exchange for ownership stakes. This lets them share in the property’s profits and losses. 
• Debt financing is when you borrow money to finance a project. Typically, the loan is secured by the property and requires regular principal and/or interest payments.

CRE Loan Types

Now that you know what CRE financing is, let’s dive deeper into different CRE loan types:

• Permanent loans. These are similar to residential mortgages, except that they typically have loan terms of 5-20 years (though amortized up to 30 years) and a balloon payment at maturity.
• SBA loans. These are loans backed by the Small Business Administration (SBA). Popular options include the SBA 7(a) and SBA 504 for loan amounts up to $5 million.
• Bridge loans. These are short-term loans (6-24 months) designed to help investors “bridge” the gap between construction or rehab and the permanent financing or sale of a property. 
• Hard money loans. These are loans issued by private lenders who, when underwriting, weigh the value of the financed asset over the borrower’s income or creditworthiness. 
• Cash-out refinance loans. These are loans that replace an existing mortgage so that the borrower can extract equity from the property to improve their liquidity and/or loan terms.

LTV Ratios & Requirements 

Commercial real estate financing institutions can have many lending criteria, including a maximum loan-to-value (LTV) ratio. 

LTV compares the loan amount to the underlying asset’s value by dividing the former by the latter. For example, a $3 million loan on a $4 million property would have an LTV of 75%. 

In other words, the borrower would have to put down the other 25% of the property’s purchase price ($1 million) to qualify for financing.  Most CRE lenders won’t go above an LTV of 80%. 

Rates & Terms

Beyond LTV limits, CRE loan rates and terms can vary widely. 

For example, permanent loans may require the financed property to maintain a minimum debt-service coverage ratio (DSCR). This helps ensure the property’s cash flow is enough to cover loan payments. 

Other CRE loans may be based on the property’s value and expected appreciation. For example, some hard money lenders may lend up to a certain percentage of a property’s after-repair value (ARV). 

Collateral Requirements 

Nearly all CRE loans collateralize the property being financed. 

This means the lender places a lien against the property as part of the loan agreement. That way, if the borrower defaults, the lender can seize the property to mitigate their losses. 

Risk Assessment

Of course, to make an informed lending decision, the lender must verify the value of the collateralized property. 

This often involves commissioning a professional inspection, survey, and appraisal. If the results reveal the property has a lower value than expected, the lender may reduce the amount they are willing to lend (and vice versa) or back out of the deal entirely.

Similarly, borrowers must conduct their own risk assessment to ensure a CRE loan won’t expose them to too much risk (aka being overleveraged).

Eligibility Requirements & Borrower Profile

While CRE lenders often underwrite based on the deal itself, borrower profile is still a factor.

Typically, CRE loan borrowers must be LLCs, not individuals. Furthermore, they may need to demonstrate a track record of successful real estate investments, provide a personal guarantee, and maintain a minimum credit score. 

Benefits & Drawbacks of CRE Loans

Before you apply for a CRE loan, consider the following benefits and drawbacks:

Pros of CRE loans

• Leverage. A CRE loan can give you more capital to invest in commercial properties. That way, you can expand your portfolio faster than you could alone. 
• Return on equity. Instead of letting equity sit idle in your current portfolio, extract it to buy additional cash-flowing properties and increase your return on equity (ROE).
• Flexibility. CRE loans come in many forms, allowing you to choose a loan based on your investment needs and goals. 

Cons of CRE loans

• Foreclosure risk. If the investment goes south and you default on your loan payments, you risk losing the underlying property and all you put into it.
• Complex loan terms. Many CRE loans have complex loan terms, including prepayment penalties and fees that can increase total loan costs. 

Loan Process

Here’s the basic CRE loan process:

1. Application. First, you must submit a loan application to a CRE lender. Don’t forget to include necessary documents, such as your investment plan, exit strategy, and track record.  

2. Underwriting. From there, the lender will verify that the proposed investment meets their basic lending criteria and commission the necessary property inspections and appraisal. 

3. Closing. After both parties settle on loan terms, the loan is finalized at the closing table (usually where the property is officially purchased from the seller).

4. Servicing. Finally, the lender releases the loan funds as a lump sum or in installments according to an agreed-upon draw schedule.

Frequently Asked Questions (FAQs)

What is CRE financing?

CRE financing is the process of obtaining funds (through debt or equity) to purchase, develop, or refinance a commercial real estate property. 

What is the difference between CRE and C&I lending?

CRE lending involves loans for investing in commercial real estate, while C&I (commercial and industrial) lending involves loans that fund a business’s operating needs or capital expenditures.

What is CRE in real estate?

CRE (commercial real estate) refers to properties used for business purposes. These could include offices, hotels, retail stores, apartment buildings, and more.

Conclusion

CRE financing is nearly essential for substantial growth of a portfolio. Without it, the real estate industry would see much less investment and development.