Commercial Loan Info - What is a Commercial Loan

A loan is an arrangement where a lender or investor grants a sum of money to a borrower for a specified term or period of time; where the borrower promises to repay the loan in full, usually accompanied by accrued interest.

A commercial loan is no different, but is used specifically to purchase a commercial property or to finance a company’s working capital needs. A commercial loan has many similarities to a residential loan and other common loans, but should be considered a completely different product all together.

The biggest difference between a commercial loan and a residential loan is that a commercial loan is written and qualified based on the amount of income the property produces; where a residential loan is written and qualified based on the personal income of the borrowers.

Commercial loans do take the borrowers personal income information and strength into consideration, but the loan amount is calculated based on the amount of income the property produces. Lenders use many different ratios and criteria to underwrite each file, but in most instances, the amount of income the property will produce will determine how much money a commercial lender is willing to lend.

All loans are written and priced on a risk based assessment. The riskier the lender sees the loan, the more they will charge to fund the money. A borrower’s personal risk rating can be determined based on a number of different factors. The first and most commonly used information is a borrower’s personal FICO (Fair Isaac Corporation) score. Borrowers with a high FICO score will qualify for the best rates available. The lower your FICO score, the higher your risk assessment, and in turn, the more you will be charged to fund your loan. (For tips on how to manage and maintain a high FICO score, please click here). Another contributing factor to a borrower’s personal risk rating will be the amount of reserves the borrower has readily available to them and their overall financial strength. These reserves can include but are not limited to cash, bonds, stocks, 401K, IRA’s, other credit lines available, etc. The more reserves a borrower has available, the less risk of the borrower defaulting on a loan.

The next thing a lender is going to consider will be the property type they are going to lend on. Usually a lender will tier property types from the most desirable down to the least desirable. Office and retail buildings usually rank in the higher tiers while buildings that could require special use permissions or may cause environmental problems are placed lower. Churches are often unattractive properties because they require a special use permit for operations. Gas stations and automotive repair shops are also unattractive properties because they could potentially contaminate the land on which they operate, such as oil or gas seeping into the soil. The less attractive the property type, the higher the risk assessment, thus the more a lender is going to charge for the money they lend.

The final and most informative assessment will be based on the income produced from the property (gross scheduled rental income), which is the final determinant of what amount the bank will typically lend on a particular property. There are a number of different ratios used to calculate this final figure, but the most important and commonly used is a DCR or DSCR ratio, which stands for Debt Service Coverage Ratio. The figure calculated from the DCR ratio will tell the lender how much income you expect to receive after you have satisfied your debt service requirements.

A DCR of 1.0 means that for every one dollar of net income, you have one dollar of debt that needs to be paid. The higher the DCR ratio, the more attractive your loan will be. Commercial lenders like to see a DCR of at least 1.0, as anything less would be a negative cash flow, but many require a minimum DCR of 1.2. This again can be dependant on the property type and the other factors included to determine the overall risk of the commercial loan.

For example, if an individual were interested in purchasing a single unit 10,000 square foot commercial property, and the rent being charged is currently $1.10/sf, that would produce a gross scheduled income of $11,000.00 (10,000 x $1.10) per month, or $132,000.00 per year. A conservative way to quickly calculate what the highest loan amount available is to take 35% off the top for vacancy, management, and reserves (for a detailed explanation of vacancy, management, and reserves, click here). From our example stated above, incorporating this calculation would give us a net scheduled income of $7,150 (11,000.00 x .65). We know in this circumstance that the lender will require a 1.20 DCR minimum, so we take our $7,150 and divide it by 1.20 which gives us $5,958.33. $5,958.33 is the total dollar amount available for debt service. This is where we integrate the figure we just calculated into our payment equation to calculate the highest loan amount eligible. So, using an interest rate of 6.5% and an amortization period of 25 years, we can calculate that the highest loan amount available for this property will be $882,429.89.

The only time the gross schedule rental income is not used to calculate the highest loan amount available, is if the property is an owner/user property, i.e. if the owner is going to occupy the property for their own business. In this instance, a lender will calculate the highest loan amount available based on the net operating income of the business that will be occupying the space. The reason for this difference is because a building owner does not usually charge his own business rent for the space which they occupy, thus a bank will apply the operating company’s net income to qualify the loan and determine how much they can afford to borrow. In many instances, there are more options available to owner-user properties, especially through the SBA (Small Business Association) or other affiliated programs. The main reason for this is because a commercial lender will consider you a lower risk if you are going to occupy the building because the borrower has a higher vested interest in keeping the property. Usually a lender will lend a higher loan to value ratio if the property will be an owner user property. Please be sure not to confuse this calculation with an investment property, as they are calculated with two completely different formulas.

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