When a business wants to purchase commercial property, but does not have the ability to pay cash for it, a commercial loan can be used to finance commercial property. These loans function in a similar manner to residential mortgages, but the criteria to qualify can be significantly more stringent.
The income of the business, along with its profits, ability to repay the loan, and the current economic conditions, will be collectively considered by the lender in assessing risk. Outlined below are the main requirements for obtaining a commercial loan.
Collateral
Typically, lenders require the property being purchased to serve as collateral for the loan. This serves to protect the lender's investment and gives them the right to take possession of the property should the borrower be unable to meet their mortgage obligations. Lenders will conduct a thorough appraisal of the property to ensure it has sufficient value to cover the amount loan in the event of a default.
Lenders use a calculation known as the loan-to-debt ratio which entails adding together the net income of the borrower and the property’s market value as determined by a recent appraisal, and then dividing the amount of the overall mortgage by this sum. Most lenders require a percentage of less than 75%.
The business is typically required to occupy more than half of the building for which they are obtaining financing. If the business is not planning to meet this requirement, an investment property loan may be more appropriate.
Cash Flow
Another important consideration is the cash flow of the business and how it compares to its debt. Most lenders prefer a steady net income of at least 20% more than the debt of the borrower. Small businesses are considered to be higher risk due to a higher fail rate; therefore, lenders generally scrutinize their finances very carefully.
To demonstrate their cash flow, borrowers will be asked to provide detailed statements of their expenses and income as well as other budget-related aspects. To determine risk, the lender will also consider the experience of the owner(s), the success rate of the business, and how long it has been operating. The borrower’s proof of assets or savings that could later be converted to cash, demonstrate their ability to pay the mortgage in the event of a major business loss.
Business Credit
The credit score of the business will also be assessed to determine eligibility as well as the terms, such as the minimum down payment required, payback period and interest rate.
A small business must be structured as an S corporation, limited liability company, or other type of business entity to qualify for a commercial loan.
Guarantor Income and Assets
In some cases, the lender may also require a guarantor for a commercial loan; this is typically the owner of the business. This person must be able to guarantee the loan will be paid in the event that the business defaults.
Lenders will review the assets, credit and income of the guarantor. To qualify, their credit score and credit history must also meet certain requirements established by the lender. Business owners with past court judgments, tax liens, defaults, foreclosures and other financial issues have a lower chance of approval.
Rental Income
If the property being financed will also serve as a commercial rental, the lender will consider the anticipated rental income in determining cash flow. The borrower may be required to sign over to the lender, their financial interest in the lease income. However, the lender will only be allowed to take that income if the borrower is unable to pay the mortgage.
How Can Small Businesses Increase their Chances of Approval for a Commercial Loan?
The approval process for commercial loans can be rigorous, but being prepared can make the process easier. There are a few steps small businesses can take to increase their chances of approval.
For a business with additional assets, offering to pledge them as collateral may satisfy some of the lender’s risk. Adding a cosigner or investor, and taking steps to improve their credit score, such as by paying off any existing debt, can also be beneficial for improving chances of approval.
In some cases, agreeing to pay a higher interest rate or bigger down payment may be a lender offered option. If a business is still unable to qualify, they may find that a less expensive property is the best way forward.
Learn More About Commercial Loans from Your Local Community Bank
Woodsboro Bank values the success of the community and works tirelessly to support local businesses. If your company is considering a commercial real estate purchase, the professionals at Woodsboro Bank will gladly provide you with personalized guidance to simplify the process. Contact us today to discuss your options and start the application process.