Understanding Commercial Real Estate Financing Options
8 min read
Commercial real estate (CRE) offers numerous opportunities for investors, but a key element in realizing these opportunities is understanding the financing options available. Navigating the financing landscape in CRE can seem complex, given the variety of loan types and structures, each with specific terms, rates, and eligibility requirements. This guide outlines the main financing options for commercial properties, equipping investors with essential knowledge to choose the right financing strategy.
Traditional Commercial Mortgage Loan
A traditional commercial mortgage loan is one of the most common financing methods for commercial real estate. These loans are similar to residential mortgages but tailored for income-producing properties, such as office buildings, shopping centres, and apartment complexes. Generally, commercial mortgage loans come with terms of 5 to 20 years, with amortization periods of up to 25 years. Unlike residential mortgages, commercial mortgage interest rates are typically higher due to the increased risk associated with CRE.
Traditional loans may have either fixed or variable rates, and lenders often look at factors such as the property’s income potential, the borrower’s creditworthiness, and the loan-to-value (LTV) ratio. This option is ideal for investors seeking long-term financing for stabilized properties, where the income generated can comfortably cover debt repayments.
Canada Small Business Financing Program (CSBFP)
For small business owners interested in purchasing commercial real estate, the Canada Small Business Financing Program (CSBFP) is designed to help small businesses access loans for purchasing or improving commercial properties. Under the CSBFP, the government provides lenders with a guarantee of up to 85% of the loan amount, allowing them to offer better terms and lower interest rates to borrowers.
Another valuable resource is the Business Development Bank of Canada (BDC), which offers financing tailored to small businesses, including loans for commercial real estate purchases. BDC loans can cover up to 100% of project costs, providing flexibility for businesses that need to invest in property while maintaining cash flow. These options are particularly appealing for entrepreneurs aiming to acquire or renovate properties for their businesses, as they often come with favourable repayment terms and interest rates.
Bridge Loan
Bridge loans are short-term financing solutions designed to “bridge the gap” while a property is being improved, stabilized, or readied for long-term financing. These loans typically have higher interest rates and shorter terms, generally between six months to three years, due to the temporary nature of the financing. Bridge loans are ideal for investors looking to acquire or renovate a property quickly, such as in value-add situations where improvements will increase the property’s market value.
Bridge loans can also be helpful for investors in competitive markets who need rapid financing for property acquisition before transitioning to more permanent financing. While bridge loans offer quick access to capital, the short repayment windows and higher interest rates mean that investors should have a clear exit strategy to refinance or sell the property.
Construction Loans
Construction loans are the type of short-term loan used to finance the building or renovation of commercial properties. These loans differ from other CRE financing options because they are disbursed incrementally as construction milestones are completed. Construction loans generally have higher interest rates and shorter terms, often lasting only until the building is completed.
Once the project is finished, borrowers may refinance the loan into a traditional commercial mortgage to secure a longer-term financing solution. Construction loans are ideal for developers working on new builds or major renovations, allowing them to fund projects without paying the entire cost upfront. However, borrowers must have a solid project plan, as lenders require detailed budgets, schedules, and sometimes developer experience.
Mezzanine Financing
Mezzanine financing is a hybrid form that combines debt and equity elements. In this structure, the lender provides a loan to the borrower with the agreement that, if the loan is defaulted on, the lender can convert their loan into an equity stake in the property. This financing is often used to fill gaps between traditional debt and equity financing, providing additional capital to complete a project without diluting ownership.
Mezzanine loans typically carry higher interest rates than traditional loans due to their riskier nature but are advantageous for investors who need flexible funding. This type of financing is popular in large-scale projects where owners may want to retain control while accessing additional capital.
Commercial Mortgage-Backed Securities (CMBA) Loans
Commercial Mortgage-Backed Securities (CMBS) loans, also known as conduit loans, are pooled loans packaged into securities and sold to investors. These loans are attractive because they generally offer competitive fixed rates and longer terms. However, CMBS loans come with strict requirements and are less flexible than traditional loans, especially if the investor needs to modify terms later on.
One unique feature of CMBS loans is their non-recourse nature, meaning the lender can only seize the property itself as collateral if there‘s a default. This feature makes CMBS loans ideal for investors who want limited personal liability in large-scale investments. CMBS financing is common for income-generating properties, such as retail centres, office buildings, and multi-family apartments.
Hard Money Loans
Hard money loans are short-term financing solutions provided by private lenders, often secured based on the value of the property rather than the borrower’s creditworthiness. These loans are generally easier to obtain but come with higher interest rates and short repayment terms. Hard money loans are ideal for investors looking to capitalize on properties quickly, especially in fix-and-flip or distressed property scenarios.
Because hard money lenders focus on property value rather than income or credit history, these loans offer flexibility for investors who may not qualify for traditional loans. However, the high interest and short repayment term mean that borrowers should be prepared with an exit strategy, such as a sale or refinancing.
Preferred Equity Arrangements
In preferred equity arrangements, the investor provides capital in exchange for a return on investment before any distribution to other equity holders. Preferred equity is advantageous in that it gives investors priority in receiving returns without taking full ownership stakes. These agreements benefit capital-intensive projects where developers or sponsors want additional financing without ceding control.
For investors, preferred equity provides the potential for higher returns than traditional debt financing. It can be beneficial when debt financing might be limited due to the project’s risk profile. However, preferred equity holders do not have the same protections as debt lenders, making it important to fully understand the risks involved.
Selecting the right financing option for a commercial real estate investment depends on factors such as property types, project scope, timeline, and the investor’s financial goals. Each financing option has unique terms, costs, and benefits. Working closely with financial advisors or mortgage brokers specializing in CRE can provide valuable insights, ensuring the financing aligns with your investment strategy and goals.
References
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Blumenfeld, A. (n.d.). Preferred equity real estate investing: What, why, & how. Layer 1. https://equitymultiple.com/blog/preferred-equity-real-estate-investing-what-why-how
Dehan, A. (2024, October 25). What are construction loans and how do they work?. Bankrate. https://www.bankrate.com/mortgages/construction-loans-explained/#what-are
Kagan, J. (n.d.). What is a bridge loan and how does it work, with example. Investopedia. https://www.investopedia.com/terms/b/bridgeloan.asp
Mezzanine financing. Corporate Finance Institute. (2023, November 29). https://corporatefinanceinstitute.com/resources/commercial-lending/mezzanine-financing/?utm_source=google&utm_medium=cpc&utm_term=&utm_content=&utm_campaign=&utm_adgroup=&utm_funnel=&gad_source=1&gclid=CjwKCAjw-JG5BhBZEiwAt7JR600uKqrnFbQ0dlMqDyLmpcQlAPrQIIUGO1d_-VmWvAE2on3tpVaI7xoCRQwQAvD_BwE
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Segal, T. (n.d.). Hard Money Loan: Definition, uses, and Pros & Cons. Investopedia. https://www.investopedia.com/terms/h/hard_money_loan.asp
Small business loan - apply online for up to $100 000. BDC.ca. (n.d.). https://www.bdc.ca/en/easy-small-business-loan-bdc?gad_source=1&gclid=CjwKCAjw-JG5BhBZEiwAt7JR6_9eyS9etRw1fgdbxfV08yT0nlofiKHB3dDPB-0Yj-lMPrpsSa5c_RoCFvsQAvD_BwE&gclsrc=aw.ds
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