Don't Get The Wrong Loan: Your Guide to Mastering CRE Financing

Any CRE investor worth their salt must know which financing works best for them.

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Investors making their first moves into the world of commercial real estate (CRE) have several big opportunities ahead of them, including stable income and long-term property appreciation.

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Yet before they start scouting properties and negotiating deals, there's a crucial element to understand: CRE financing. 

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This is the fuel that propels the CRE investment engine, making the purchase and development of commercial properties possible. 

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Yet knowing how to finance a commercial property isn’t a walk in the park. Knowing how it works and which type is best for each property deal is a skill that requires time and patience. 

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This guide is a great place to start. We’re going to cover:

• What CRE financing is and who supplies it?
• How is CRE financing different from residential lending?
• Who are the most common types of CRE lenders?
• What are the most common types of CRE finance? 
• CRE glossary: The essential CRE financing terms you should know
• What is the difference between CRE and C&I lending?
• Is CRE financing typically interest-only?
• Are CRE loans fixed or floating?
• The importance of choosing the right CRE loan

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What is CRE financing and who supplies it?

Commercial real estate (CRE) financing is the means for investors to fund the purchase (and/or development) of office buildings, multifamily housing, or retail space.

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A diverse financial toolbox, CRE financing covers various loan types. As an investor, you may want to apply for long-term financing like a mortgage loan, or short-term solutions like bridge loans or funding earnest money deposits.

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Most CRE funding still comes from traditional lenders like banks, credit unions, and the Small Business Administration (SBA), although the big bank dominance of the market is waning. 

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Just 12.1% of CRE financing in the United States comes from the Fed’s “Top 25 Banks”, according to recent data from research company Moody’s Analytics.

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Source: Moody’s Analytics

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The gap in CRE finance left behind by large banks is quickly being filled by alternative lenders, like fintech startups, and peer-to-peer (P2P) lenders. 

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These entities are capitalizing on strict lending requirements imposed by traditional lenders, which often include a high credit history and detailed financial statements. 

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Instead, they use new assessment methods (often involving artificial intelligence) to build a more nuanced picture of the borrower’s creditworthiness, including future invoices and the property’s cash flow potential.

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How is CRE financing different from residential lending?

The obvious difference between commercial and residential loans is that CRE financing is for business purposes, not personal use.  

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For this reason, commercial properties are typically larger investments with higher risks compared to residential real estate. 

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Commercial lenders have stricter requirements, focusing heavily on the borrower's creditworthiness (including credit score and financial statements) and the property's value and income potential.

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Who are the most common types of CRE lenders?

While traditional banks and credit unions might be the first institutions that come to mind, the landscape of CRE lending now extends far beyond them. Here's a look at some of the key players:

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1. Traditional lenders

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Steady and conventional, traditional lenders are probably what your parents and grandparents used for their financing.

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Banks and credit unions are the main examples, and they remain significant players offering long-term financing options. As mentioned earlier, however, their lending requirements are often very strict. 

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2. Alternative lenders

Private equity lenders, debt funds, and hard money loan providers are increasingly filling the gaps left by traditional lenders. 

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As journalist Hugo Cox writing for the Financial Times put it recently: “Instead of investing in the buildings themselves, many individuals are now switching to lending cash to those who do.

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It makes sense. For people and businesses with access to capital, lending provides a quicker return than investing in real estate themselves. A fundraising spree since the pandemic has pushed global private lending to record levels.

                                          Source: Financial Times

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This type of lending tends to come with more flexible terms and faster approvals but may come with higher interest rates, fees, and shorter loan terms.

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3. Government programs

In the US, the Small Business Administration (SBA) offers loan programs specifically for small business owners looking to invest in commercial real estate. These loans often have more favorable terms and lower down payments.

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What are the most common types of CRE finance? 

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Each CRE investment is unique, and so are the financing options available. Here's a breakdown of some common CRE loan types.

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1. Permanent mortgage

Mortgages are long-term loans that provide the bulk of the funding for any property purchase. 

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They come with fixed or adjustable interest rates and amortization periods of up to 30 years. These may even extend beyond the loan term, which means you pay down the principal over a longer period. 

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2. Bridge loans

These are short-term solutions that provide temporary financing for a specific purpose, like buying a property you plan to renovate before renting or selling it.

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3. Construction loans

No prizes for guessing that these loans finance the construction of a new commercial property. They are typically short-term and have stricter requirements than permanent loans.

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4. Lines of Credit

Lines of credit function similarly to a credit card. You have a borrowing limit and can draw on funds as needed, making them ideal for covering ongoing expenses or unexpected repairs.

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They often offer more flexible repayment terms than credit cards, however, often require a security deposit or collateral. 

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CRE glossary: The essential CRE financing terms you should know

Investors who get more involved in CRE financing will come across several unfamiliar terms that may confuse them.

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Here are some CRE-specific terms and what they mean.

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1. Loan-to-Value Ratio (LTV)

Often a lender or broker will ask investors the LTV they’re looking for and this is simply the loan amount compared to the appraised value of the property. 

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A lower LTV indicates a lower risk for the lender and potentially translates into better loan terms for the investor. 

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With commercial real estate lending tight nowadays, LTVs have suffered in the US market.

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2. Debt Service Coverage Ratio (DSCR)

This ratio measures a property's ability to generate enough income to cover its debt obligations, including the loan payment. 

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“A high DSCR indicates that a company can comfortably meet its debt payments, which is a sign of financial stability”, says Todd Adams, MBA, Senior Vice President and Director of Sales at finance provider Lendistry.

If a DSCR is weak, on the other hand, then it’s very difficult to secure the right financing. 

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3. Net Operating Income (NOI)

One of the most useful stats for CRE lending is the income a property generates after deducting operating expenses (think utilities, property taxes, and maintenance).

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Known as Net Operating Income (NOI),  It's a key metric for lenders to assess the property's cash flow potential.

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4. Underwriting

Underwriting is the process a lender goes through to assess the risk of approving a loan.

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In CRE financing, underwriters will heavily scrutinize the borrower's creditworthiness, the property's value and income potential, and the overall project feasibility before making a lending decision. 

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A strong understanding of these factors is crucial for both lenders and investors navigating the CRE market.

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

Commercial Real Estate (CRE) and Commercial and Industrial (C&I) lending often get confused, but there are some important differences.

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CRE lending focuses on the purchase and development of commercial properties, while C&I  relates to the operations that take place within them, including purchasing equipment or funding inventory. This means C&I borrowing is usually shorter term, sometimes only lasting a few months.

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CRE lenders normally ask for the property itself to be the primary loan collateral, while C&I may be secured by various assets depending on the purpose and type of loan. This could include equipment, inventory, or even a blanket lien on the business entity's assets. 

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Interest rates are higher for CRE lending and can be fixed, while C&I rates are normally variable. The latter also tend to get approved faster.

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In a nutshell: CRE lending vs C&I lending 

Is CRE financing typically interest-only?

The short answer is “No”: CRE financing is not typically interest-only. 

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Unlike some residential mortgages, most CRE loans require borrowers to make principal and interest (P&I) payments throughout the loan term. This means the monthly payment goes towards paying down the loan amount (principal) in addition to the interest charged.

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However, some lenders may offer CRE loans with an interest-only period during the first years of the loan. This can be helpful for investors who are building out a property or waiting for a new tenant to occupy the space. 

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It's important to remember that after the interest-only period ends, the loan will transition to a full P&I payment structure.

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Are CRE loans fixed or floating?

CRE loans can be structured with either fixed-rate or floating-rate interest.

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Fixed-rate loans offer monthly payments at the same amount throughout the loan term. This can be ideal for investors seeking stable budgeting and long-term planning.

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Floating-rate loans, on the other hand, have interest rates that adjust based on market conditions. While they may offer a lower initial rate than fixed-rate loans, they also carry the risk of higher payments if interest rates rise.

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The choice between fixed and floating rates depends on an investor’s risk tolerance and real estate investment goals.

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The importance of choosing the right CRE loan

It’s a sad fact that many commercial real estate loans go wrong. 

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Continued high interest rates and a shift in tenant demand make this a particularly risky period for CRE financing. Delinquent loans reached $24.3 billion in 2023, more than double the previous year, according to data firm MSCI, while a further $38 billion of US office buildings are threatened by defaults. 

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Selecting the right commercial real estate financing, then, is a crucial task. Investors should consider the following questions:

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1. What are the investment goals? 

Is the property a quick turnaround, known as flipping commercial real estate, or something more long-term with a stable income?

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2. What type of property is the target?

Different types of commercial properties have varying financing requirements, ranging from traditional commercial mortgages for office buildings to construction loans specifically designed for financing the development of new properties. 

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Some lenders also specialize in financing niche asset classes like mixed-use developments or industrial warehouses. 

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3. What’s the borrower’s financial situation?

Creditworthiness and available capital will influence the loan terms a borrower qualifies for.

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4. Is refinancing an existing loan a consideration?

Refinancing can be a strategic move for existing CRE owners. If interest rates have dropped significantly since the loan origination, refinancing can lower the monthly payment and improve cash flow. 

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However, refinance often comes with its own closing costs, so a careful analysis of the potential benefits is crucial.

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5. What is the lending for?

Often investors get roped into inappropriate lending because they take out a long-term commercial loan to cover short-term expenses or put down an earnest money deposit.

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Matching the right lender to funding needs can save a lot of time and money. Different financial institutions specialize in various CRE loan types. A lender experienced in income-producing properties, for example, will likely have a better understanding of your needs and offer more competitive terms compared to a lender focused solely on owner-occupied business loans. 

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Researching and approaching the right lenders can also quicken the approval process and will help you secure the most suitable financing for your specific CRE investment.

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