Financing Guidelines for Commercial Properties

Although there are similarities between residential and commercial mortgage, there are specific guidelines and rules that apply for financing commercial properties, which comprise structures such as office buildings, apartment complexes, healthcare facilities and retail outlets. Commercial financing typically involves a lot more paperwork.

While an individual borrower’s credit rating is the primary qualifying factor for residential home financing, commercial mortgages are in most cases underwritten based entirely on the attributes of the property being mortgaged. Since commercial mortgages are typically assumed by businesses instead of individual borrowers, lenders not only require the business to be stable and creditworthy, but they also require the individuals that own the business to have positive personal credit ratings.

Besides checking credit ratings, underwriters also look at the location of the business being purchases, past income generated, as well as projected income. The commercial mortgage terms also depend on the type of business the borrower is involved in and the type of premises or facility that the borrower wants to purchase. The first step in underwriting a commercial property is to calculate the property’s cash flow, which is commonly referred to as net operating income, or NOI.

Debt coverage ratio or DCR, which is defined as the monthly debt compared to the net monthly income of the investment property in question is one of the key components in the loan evaluation process. Lenders typically seek a minimum debt service coverage ratio which ranges from 1.1 to 1.4, which is a net cash flow ratio of the income the property produces and the debt service or mortgage payment. Lenders also consider Loan to Value or LTV. LTV is the amount of a mortgage as a percentage of the total appraised value. Commercial mortgage LTVs are usually between 55% and 70%, unlike residential mortgages which are typically 80%.

The most common commercial mortgage is a fixed-rate loan, where the interest rate remains constant throughout the term. In residential mortgages, the word “term” indicates the time period of the loan during which the interest rate is fixed, as in a 15-year or 30-year term. On the other hand, most commercial loans require a total payoff, known as a balloon payment, after a certain time frame. The length of time allowed between the amortization and the balloon payment is known as the term. For example, if a loan had a 30-year amortization schedule, with a 10-year term, it would be referred to as a 10-year balloon with a 30-year payment schedule.

Unlike residential mortgages, commercial financing often includes a prepayment penalty. This is done because lenders make their money on the interest that is paid throughout the life of the loan and prepayment can cut short their profits. However, in today’s competitive commercial loan market, borrowers can negotiate for the elimination of the prepayment clause.