How Commercial Loans Work

December 12, 2019

How Do Commercial Loans Work?

Commercial is just a fancy word for business, so a commercial loan is just a loan to a business.  The loan can be secured by an apartment building, other commercial real estate, accounts receivable, inventory, equipment, or, for very strong borrowers, only by a personal guaranty (lines of credit).  More below. 

What is a Commercial Loan?

To understand how commercial loans work, you first need to understand what is a commercial loan.  It is actually a little easier to understand what a commercial loan is not.   A commercial loan is not a loan secured by a single family dwelling, a condo, a duplex, a triplex, or a four-plex, where the purpose of the loan is for personal, family, or household purposes.  By the way, single family dwellings, condo's, duplexes, triplexes, and four-plexes are referred to as one-to-four family dwellings.  Such properties get special treatment and enjoy much lower mortgage rates.

Example #1:

You live in one half of a duplex.  Your kid is going away to college, and you need to pull $40,000 out of the equity in the house to pay for her first year's college tuition.  This is a residential loan.  Suppose the purpose of the loan was to pay for medical bills.  The loan would still be a residential loan.  Suppose the purpose of the loan was to consolidate your personal credit cards.  This is still a residential loan.

Why does it matter?  Residential real estate loans enjoy interest rates that are about 0.625% cheaper than commercial mortgage loans, so you will want to apply to a garden-variety residential mortgage lender, like a bank or a big mortgage banker, such as Quicken Loans.

Example #2:

You own a five-unit apartment building, and you want to pull out $100,000 to go on a gambling spree in Macau (China).  This is considered a commercial loan, even though you are using the proceeds for a personal purpose (gambling), because the property has five or more residential units.  Your printing company want to buy a new printing press, and the bank finances the purchase, secured by the new equipment.  This is a commercial loan.  Your janitorial service needs cash, and you pledge your outstanding invoices for an accounts receivable loan.  This is a commercial loan.

Here is a suprising one:  You want to start a business, and you borrow $100,000 against your owner-occupied single family dwelling.  Legally, this is considered a commercial loan because the purpose of the loan is NOT for personal, family, or household purposes; but you should still apply to a resdiential lender like Quicken Loans.  They will treat it like a residential loan, and they will give you far better rates than any commercial loan. 


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Who Makes Commercial Loans?

A "conventional" commercial real estate loan is one that is not guaranteed by any governmental agency, such as the SBA, the USDA, or Fannie Mae.  The overwhelming majority of all conventional commercial loans are made by either banks or credit unions.

If you are buying an office building or an apartment building as an investment property, perhaps to serve as your retirement income someday, you will need to obtain a conventional commercial loan.  Conventional commercial real estate lenders typically require a minimum down payment of 25% to 30% of the purchase price.  

SBA lenders will only require a 10% down payment, if you have operated your business for at least three years, and you are buying the property to be occupied by your business.  Your business must intend to occupy 51% of the property.


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Down Payment Strategies

Unfortunately, buyers of commercial property are no longer allowed to ask the seller to carry back a second mortgage behind the bank's new first mortgage.  Your down payment must be cash.  Banking regulators, after the Great Recession, will not permit it.

If you have no down payment at all, you are out of luck.  Sorry, but you are smoking Colorado oregano if you think you can buy a commercial property with nothing down.  Nice try.  :-)

If, however, you have a sizeable down payment, but not just the full 25% to 30% of the purchase price to satisfy the bank, you might try asking the seller to carry back a second mortgage on your personal residence for the shortfall in your down payment.  


For example, suppose you are buying a small office building for $1 million, but you only have $220,00 to put down.  The bank wants you to put down 30% of the purchase price or $300,000.   You are short $80,000.  The seller might be willing to carry back that $80,000 as a second mortgage on your personal resixdence at, say, 7%.  That's a much higher interest rate than he could earn elsewhere.

You could alternatively ask the seller to carry back a second mortgage on another investment property that you own, like an apartment building.

My own private money commercial lending company, Blackburne & Sons, will often allow the seller to carry back a second mortgage behind our new first mortgage.


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Down Payments on USDA Business and Industries Loans

The U.S. Department of Agriculture has a commercial loan program, known as the Business and Industries ("B&I") Loan Program, for properties located in small towns.  The program is very similar to the SBA loan program.  Some of the poorest Americans live in small towns and rural areas.  The idea behind the USDA B&I loan program is to bring manufacturers and other businesses to rural Amercia in order to create jobs.

The down payment requirement on USDA B&I Loans is similar to that of SBA loans.


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Importance of Net Worth:

When applying for a conventional commercial loan from a bank, a borrower needs to make sure that the size of his commercial loan request is reasonable compared to his net worth.  For example, a borrower with a net worth of just $200,000 probably is not going to qualify for a $5 million loan.  The general rule is that the borrower's net worth needs to be at least as large as the size of the commercial loan he is seeking.  In the parlance of commercial real estate finance (CREF), the Net-Worth-To-Loan-Size Ratio needs to be at least 1.0.


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