Commercial real estate is popular in the investment world, and with good reason: Not only are commercial properties likely to appreciate in value over time, but they generate rental income in the near term. However, commercial real estate loans (CRE loans) work somewhat differently than residential mortgages, so it can be helpful to understand the details before getting started.

First, while residential mortgages are obtained by individuals, it can be advisable to set up a business entity when purchasing commercial real estate. Doing so will help keep your personal finances and business interests separate. Your business will be the entity that owns the property and collects rent from tenants.

CRE loans can be obtained via local and national banks, credit unions, and even through the Small Business Administration program for commercial real estate. These lenders will require financial documentation from you, including tax returns and historical financial statements. This information helps lenders determine your creditworthiness before approving you for a loan.

Lenders will also assess the loan-to-value (LTV) ratio and debt service coverage ratio (DSCR) for the property you intend to purchase. LTV refers to the ratio of the loan amount you are seeking and the value of the property. In commercial real estate, lenders expect the LTV ratio to be no more than 80% and possibly as low as 50-60%. DSCR refers to the ratio of the net operating income of the property and the cost of the mortgage, both on an annual basis. Because commercial properties are expected to generate rental income which should be used in part to cover the loan payments, lenders expect the DSCR to be in the range of 1.15 to 1.35. This means the property has a positive cash flow and can effectively service the loan.

CRE loans also have shorter terms than residential mortgages, ranging from five to 20 years. The amortization period may be longer, which means that the final payment on a CRE loan may be a balloon payment for the balance due. Loans with longer repayment periods will have higher interest rates, as will loans to borrowers whose credit may be slightly impaired. Finally, loans for commercial property are also likely to incur penalties for early repayment. Lenders anticipate a certain yield for such loans, so a business cannot pay off a loan early and save money on interest. Instead, the lender will assess fees or penalties to ensure the yield remains fixed.

This has been merely a brief introduction to the ways in which CRE loans are approved, structured and executed. Before taking any further steps to invest in commercial real estate, it could be helpful to speak with both an attorney and an accountant.