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Financial considerations for commercial mortgages

How much cash do you have available to buy commercial property? Since most commercial mortgages start around $500,000 and you need at least 20% in cash for the down payment, you must have a strong cash basis before meeting with a single lender.

Let’s start by investigating two important factors that a commercial mortgage lender will look at to determine if you’re a strong enough candidate:

  1. Loan-to-value ratio (LTV) – Consider how much you need to borrow to buy the property and divide that by the appraised value of the property. The lower this ratio is, the better your interest rate will be. A strong LTV, for example, would be 70% to 75%.
  2. 2. Debt service coverage ratio (DSCR) – Your DSCR means the property you are considering will make you more money than the expenses of your monthly mortgage payments. Lenders take your net income and divide it by the interest and mortgage payment for the month. This ratio needs to be a minimum of 1.25 to be a low risk candidate for a mortgage.

Keep in mind: you still have your regular business expenses and business responsibilities that your income needs to cover. You must be able to comfortably handle those expenses and your mortgage before you can move forward.

Can I afford a commercial mortgage?
So now it’s time to see if your business is a candidate for a commercial mortgage. Since they usually cost $400,000 to $500,000 at a minimum, you must have at least 20% to 30% of that to cover your down payment. Unlike a home mortgage, there’s little wiggle room for how much you can put down to qualify for the mortgage.

Next, find out how risky the business is that you’re considering. As a general rule of thumb, pre-existing businesses with a proven track record are good investments. But if you want to open a local gas station or a new restaurant in a neighborhood unaccustomed to new eateries, you’ll face more difficult challenges. You may need to pay extra for environmental testing to see if the property you want is safe.

How long do you want to borrow the money? You can get a commercial mortgage for 15, 20, or even 30 years. The longer you extend a mortgage, the less you’ll pay, but you’ll be paying more interest over a longer period of time. And if you try to pay off a commercial mortgage quickly to save on the interest, you may be responsible for early repayment charges – penalties for paying off the mortgage before lenders can collect the full interest.

It’s extremely important to keep up your finances when securing a commercial mortgage because you could lose the building to the lender! By defaulting on payments or having a DSCR below 1.25, the bank can foreclose on the property to best recoup their losses! If you’re not 100% sure you can make the money to comfortably keep up with payments, you may want to rent property for a while longer until you’re certain you can afford it.

Commercial Mortgage Costs

The first cost to consider is also the most important – the interest rate. There’s little wiggle room as most commercial mortgage lenders base the rate on the prime rate that the banks set. This varies based on market fluctuations but it was hanging steady at 8.25% as of early 2007.

Lenders will tack on a percentage to the prime rate to compute the interest you’ll pay on the total amount of the loan (minus down payments.) This can be as little as a quarter percent (for very large mortgages) or several percentage points (for smaller mortgages less than $500,000.) Your lender may be willing to negotiate a lesser percentage based on the length of your loan term and how risky a prospect your business property is.

Remember: the bulk of your initial expenses will come from the down payment of 20% to 30% of the agreed-upon cost of the building. So if you’re buying a $1 million piece of property, expect to have $200,000 to $300,000 ready to hand over to the lender at closing.

In addition to the down payment and interest rate, anticipate spending several thousand dollars more for closing costs, appraisals, environmental testing, broker fees, legal costs, and any other fees that a lender deems necessary.

And your expenses don’t end at the closing either! In addition to monthly mortgage and interest payments, you have to keep in mind early repayment charges and balloon payments. If business is doing well and you want to remove the burden of the mortgage from your plate, you may have thousands of dollars to fork over to the lender. Likewise, if you’re paying down a low-interest, low-payment loan with a balloon payment and approaching the finish line, make sure you’re ready pay that large lump sum that’s due. Otherwise, you’ll need to negotiate a new mortgage.