Commercial loans in their basic form are a lending agreement between a business and a financial institution or private lender to finance the growth or operation of their business. These loans can be for variety of reasons and come in many different forms to serve a businesses needs. Some of these reasons would include acquiring equipment, purchasing the property for which the business operates from, a line of credit to meet working capital needs, construction, business start-ups, business acquisition, refinancing property or term debt, hard money loans, and more. Here are 5 commercial lending basics you may want to know if you are seeking your first commercial loan.
Application Process / Time Frame
A commercial loan application is much more extensive than a consumer application. While commercial loans are less regulated, the underwriting process is much more rigorous and detailed. Borrowers must be prepared to provide specific documentation relating to their business, including two to three years of tax returns, financial statements, accounts receivables and accounts payable report documents, as well as any information pertaining to collateral that may be offered to secure the loan and potentially a business plan.
The time frame tends to be longer as the underwriting process may include commissioning and review of various third party reports, such as an appraisal or environmental inspection, in addition to the financial review of the business and owner(s) or guarantor(s). On average, a commercial loan may take 60 to 90 days to get to closing, however this time frame may be shorter or longer depending on the complexity of the deal.
Cash Flow Factors
With a commercial loan, lenders are evaluating the business or property’s ability to generate income to repay the loan, rather than solely evaluating the individual as one would with a consumer loan. In general, a lender will want to ensure adequate cash flow is available to pay all current debt obligations of at least 1.25x. This measure that lenders look at is call the Debt Service Coverage Ratio (DSCR), which takes the net operating income of a business and divides by the total debt the business is obligated to repay.
The loan to value, or LTV, is another key factor reviewed by lenders. Simply defined, this is the measure of the loan amount against the value of the collateral. In the case of real estate it is typical to see an 80% LTV requirement, which means the Borrower would be looking at putting 20% down of their own cash.
Commercial loan terms are typically 5 years or less, with the amortization period longer than the term of the loan, up to 20 to 25 years. You may be wondering why 5 years? There are so many variables that can happen across any kind of business market within that time span, that most lenders do not want to accept the risk of fixing a commercial loan rate for a longer period of time.
The interest rate that one obtains for a commercial loan all depends on the type of business, its financial condition and the strength of the owner(s) or guarantor(s), and the type of loan one needs. Be prepared for the interest rate to be higher than consumer rates, as businesses are risker to lend to in general.
Fees involved with commercial loans can be requested to be paid up front, or possibly be bundled into the loan. Examples of fees one can expect to see include covering the property appraisal cost, legal costs, loan application or origination fees, and survey fees. In addition, most commercial loans have pre-payment penalty fees for paying your loan off early. The fees will all depend on the level of risk your loan poses, the nature of your business or property type, and are often set on a sliding scale.
Lenders in most circumstances will want collateral, something of value they can hold as security, in case you default on your loan. Examples of collateral include accounts receivable, equipment, inventory, real estate, and/or a personal guarantee. A guarantor is a person, usually the business owner, who guarantees to pay the debt should the business default on the loan obligation. The type of collateral required all depends on the nature of your business, as well as the terms and conditions of the lender. It is not uncommon for owners to be expected to sign as guarantors in addition to pledging collateral.
Follow Up Once Your Loan Closes
Often times, there are conditions that are part of the commercial loan agreement that a business borrower is required to meet after the loan closes. Examples of loan conditions, or covenants as they are known, include maintaining proper levels of insurance, and/or supplying quarterly or annual audited financial statements to the lender so they can monitor the health and performance of your business.
Now that you know some of the basics, where do you go to find a commercial loan? There are a variety of lending sources out there including major and local banks, credit unions, specialty lenders and brokers. At Commercial Lending X, we specialize in helping Borrowers navigate through what can be an overwhelming process and use our expertise and lending relationships to find the right solution to best meet your needs.