A commercial mortgage constitutes credit extended utilizing real estate as collateral to secure repayment of the extended credit.
A commercial mortgage is comparable to a residential mortgage, with the exception that the collateral is a commercial building or other business-related real estate, rather than residential property.
Furthermore, commercial mortgages are customarily pursued by businesses rather than individual borrowers. The borrower may be a conglomerate, a partnership group, an incorporated business, a limited company (LC), or a limited liability company (LLC.), which makes an evaluation of the creditworthiness of the business more convoluted than is the case with simple residential mortgages.
Two important factors in obtaining a commercial real estate mortgage are robust credit and a secure business plan. The crucial factor the lender looks for is the available cash flow. There are two vital ratios a lender also wants to see to ascertain whether you can routinely make prompt payments: loan to value (LTV) and debt service coverage (DSCR).
The LTV, loan to value ratio, is determined by the amount the business owner would like to borrow divided by the appraised property value. For example, if the down payment is 25% and the balance of the purchase price is financed, the LTV is 0.75. The lower the ratio is, the better the prospect for lower interest rates.
Debt Service Coverage Ratio (DSCR) is in actuality a “financial cushion” which guarantees the property will support more income than is necessary to make monthly mortgage payments. Lenders calculate the DSCR by dividing the net income by the monthly interest and mortgage payments. The DSCR must be a minimum of 1.25 or greater to be considered a low risk for a loan.
Keep in mind that neither ratio accounts for day-to-day facility operating expenses. You still need enough cash to cover such costs as employee payroll, utilities, supplies, and marketing.
In general, commercial real estate mortgages start from $400,000 to $500,000 or more, depending on the location. To secure this type of commercial mortgage, a particular business will need to make a substantial down payment. Commercial lenders will require approximately 20-30% in down payment. Some lenders may agree to 10% down payment if other financial holdings look substantial enough, however, a more significant interest rate may be required. Unlike residential real estate, it is unheard of to finance commercial property with “zero money down”.
In the case of a mortgage, cash shortages are particularly hazardous to investment since the building is the collateral for the real property loan. If payments are missed, or the DSCR drops below 1.25, the lender can foreclose on the building to recover any losses they incur. If purchasing a property means overextending finances, it is recommended to continue leasing until the business is in a more significant cash position.
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