There are many things to account for when taking out a loan for commercial real estate, and one of the most important elements to pay attention to is the rate. A loan’s interest rate is the amount charged by the lender to the borrower for the use of assets, and is expressed as a percentage of the loan capital.
There are a number of variables to consider when looking at interest rates for a potential loan—including whether it is fixed or variable and whether or not it is fully amortized. But how are loan rates determined, and what outside factors influence them? Understanding the rationale behind commercial real estate loan rates will help you make a more informed decision when the time comes to choose a lender.
Step 1: Look at the Economy
One of the biggest factors that affect the interest rate of a loan are the current economic conditions. Interest rates are generally set in relation to the prime rate. The prime rate is the rate banks charge their customers for short- and medium-term credit. (You will see notations such as “Prime + 1.5,” which means 1.5% above prime rate.)
Every lender can set its own prime rate, but most banks use the rate The Wall Street Journal compiles from the country’s 30 largest banks. These 30 banks, in turn, strongly base their decisions on the Federal Funds Target Rate, set by the Federal Reserve Board, which is adjusted when necessary to best limit inflation.
The prime rate in mid-September 2017 was 4.25%. This is low from an historical perspective, although the rate was 3.5% a year earlier. For example, in August 1984, it was 13%.
The interest rate for the Small Business Administration (SBA) 504 loan is based on the market rate for 5 and 10-year U.S. Treasury issues, and is not actually set until the loan is funded. Your conventional lender provides a bridge loan to cover the cost of construction or purchasing during project implementation. The 504 loan is then closed after project completion. At that point, the 504 loan is submitted to the SBA and pooled in a monthly debenture sale. This means that private investors buy that debt, and are the ones who provide the actual money for the 504 loans.
The interest rate on the 504 loan is set at that time. Treasury issues follow a trajectory set by the market. This is not identical to the course of the prime rate, but it is often close to it. Using the Treasury issue rate as a base, an interest spread is negotiated with the investors. Since the borrower makes a monthly payment and the investors receive semi-annual payments, the borrower’s rate is lower than the Treasury rate plus the spread. Two small fees are added to the borrower’s payments. They go to the SBA and CDC.
Step 2: Look at the Lender and Loan
Conventional lenders will take a few factors into account when determining the final rate they offer. These factors can include:
- Prevailing rates based on the prime rate, or Treasury issues in the case of the SBA
- Your personal credit rating and the rating of your business
- The term of the loan, since longer loans generally have higher interest rates
- Other conditions on the loan, such as the size of the down payment or whether the interest rate is fixed or variable
Commercial banks will take these things into account and determine a rate for your loan individually. They are the most selective about who they will lend to, so their rates tend to be more favorable among conventional lenders.
Companies that provide loans but are not banks are called independent or private lenders. The lender is going to make a decision based more on the property you are buying rather than your creditworthiness. Loans of this kind usually have the shortest terms and highest interest.
Conditions on 504 loans are much more uniform than those of conventional lenders. All borrowers with loans that fund in the same month receive the same rate on their loans, and terms don’t vary. These loans are administered by a Certified Development Company (CDC), a nonprofit organization set up specifically for that purpose. The CDC partners with a conventional lender to create a loan package with three parts:
- The first part is a loan from a conventional lender for 50% of the total amount. You and that lender determine the amount and conditions of that loan, which becomes your first mortgage.
- Your CDC facilitates a separate SBA loan of 40% of the total, up to $5 or $5.5 million, at a fixed rate for 10 or 20 years. This will be your second mortgage.
- Then you, the borrower, will contribute 10% to the loan. Certain types of facilities are classified as single-purpose properties by the SBA and require a 15% down payment.