Commercial real estate loans aren’t the same as residential home mortgages, and they come with higher interest—usually 0.5% to 1% above the 30-year prime residential rate. Commercial loans also have shorter repayment terms, between 5 and 25 years, and are considered a higher risk for lenders because business real estate is typically harder to resell upon default than residential property.
An interest rate—what a lender charges you for the service of loaning capital—is determined by three factors: a base rate, which can be the US Prime Rate (5.25% as of November 2018) or the international LIBOR (London Interbank Offered Rate, measured monthly and measured at 2.28% as of November 2018); the length of the loan’s repayment term; and the overall amount of the loan. Interest on loans can be set at variable rates (meaning the percentage will fluctuate as the base rate does) or fixed rates (meaning the percentage remains consistent throughout the loan’s repayment term).
The worth of income-producing properties is measured by the loan-to-value (LTV) ratio, which is the total amount of the loan divided by the appraised property value or purchase price. The LTV for an $80,000 loan on a $100,000 property would be 80% ($80,000 ÷ $100,000 = 0.8 or 80%), for example.
Commercial loans come with a built-in expectation that interest will be paid over a set amount of time, ensuring that the lender will receive a continuous stream of revenue for the duration of the loan’s term. When a borrower decides to pay off a loan early, whether to refinance at a lower interest rate or get out early in anticipation of a higher rate in the future, they can—and most likely will—face prepayment penalties.
The borrower would then pay the difference between the loan’s original interest rate and the current rate for the remainder of the term of the loan (called yield maintenance) or offer up another mode of collateral, such as treasury bonds (referred to as defeasance). If your business is doing well and you can afford it in the short term, you’re in a slightly better position to take the hit of a prepayment penalty. A cash-strapped business, on the other hand, should probably avoid deviating from the loan’s term.
The simplest way to guarantee that you’ll get low interest rates is to maintain a high personal FICO credit score, the upper 700s being the ideal. Putting in a larger down payment will also help keep interest rates manageable, as will opting for longer repayment schedules when you can. Thinking long term, working with the same lender over multiple deals can establish a relationship and confidence that will lead to more lenient commercial mortgage rates in the future.