What is a Commercial Equity Line of Credit? Exploring Types and How it Works

CEO Khai Intela
In the world of real estate, equity holds significant value. It represents the difference between the worth of your property and the amount you owe on it. The greater the equity, the more collateral you...

In the world of real estate, equity holds significant value. It represents the difference between the worth of your property and the amount you owe on it. The greater the equity, the more collateral you have to offer and the higher the loan you can secure. This equity can be leveraged to borrow funds from a bank or private lender, creating opportunities for growth and financial flexibility.

Understanding Commercial Real Estate Equity

When we talk about "commercial real estate equity," we are referring to the equity that you have built in your property. The remaining portion is the sum owed on the mortgage. To illustrate, let's consider an example: let's say your commercial property is valued at $1 million, and the outstanding mortgage is $200,000. In this case, your equity in the property amounts to $800,000.

Image explaining how commercial real estate equity is calculated Image: Example of how commercial real estate equity is calculated.

This equity can enable you to raise a loan or establish a commercial real estate equity line of credit.

Types of Commercial Equity Lines of Credit

A commercial real estate equity line of credit, also known as a CELOC, provides property owners with a loan against the equity held in their property. What sets a CELOC apart is its flexibility. You can borrow as much or as little as you need, allowing you to tailor your borrowing to your specific requirements. For instance, if you have set up a $800,000 asset-based real estate equity line of credit but only require $500,000 at the moment, you can draw on the CELOC for that amount and pay interest accordingly. The remaining $300,000 can be accessed later as needed.

When choosing a commercial equity line of credit, consider two key factors:

  • Credit rates: Commercial real estate private equity lines of credit are generally more expensive than those offered by banks. However, negotiation skills may yield better rates from either type of lender.
  • Loan term: The repayment term of a CELOC affects the monthly installment amount. Shorter terms result in larger installments, while longer terms offer more flexibility.

It's important to note that although a CELOC is a revolving line of credit, it can be converted into a 5 or 10-year amortized loan after a specific number of years.

How Do Commercial Equity Lines of Credit Work?

The principle behind a commercial equity line of credit is simple: a lender sets a predetermined borrowing limit for a commercial property owner, with the equity in the property acting as collateral. The credit limit Loan-to-Value (LTV) ratio, typically ranging from 70-75%, determines how much a property owner can borrow.

Repayments are typically made over a period of 5-10 years after the initial revolving term concludes. It's important to meet the repayment obligations, as failure to do so grants the lender the right to seize the collateral to recover their losses.

Image explaining how commercial equity lines of credit work Image: How commercial equity lines of credit work.

Loans vs. Lines of Credit

It's crucial to differentiate between a commercial real estate loan and a commercial real estate equity line of credit. A loan involves a lump sum disbursement, while a line of credit provides access to funds as and when needed. Furthermore, there are several other distinctions:

Commercial Real Estate Loan:

  • Funds are disbursed once.
  • Interest is payable on the entire loan amount from the disbursement date.
  • Fixed repayments based on the interest rate and loan term.
  • Typically used for large-value purchases or equipment acquisitions.

Commercial Real Estate Equity Line of Credit:

  • Borrow up to a specific limit and repay the borrowed amount before borrowing again.
  • Pay interest only on the funds you draw.
  • Repayments are flexible during the revolving term.
  • Funds can be used for various business purposes and provide quick access to capital.

Purpose and Benefits of Commercial Real Estate Equity Line of Credit

A CELOC offers numerous benefits that make it an attractive financing option:

  • Access to Cash: CELOCs provide access to funds at short notice, allowing you to capitalize on new investment opportunities.
  • Working Capital Needs: When liquidity is tight, funds from a CELOC can help you meet short-term financial requirements.
  • Diverse Uses: CELOC funds can be utilized for capital purchases, renovations, hiring employees, or even funding a marketing campaign.
  • Tax Benefits: Property owners can deduct the interest paid on the line of credit when calculating their taxes.

How to Obtain a Commercial Real Estate Equity Line of Credit

Acquiring a CELOC is contingent on the equity you can offer as collateral for your business property. Lenders rely on this collateral to recover their funds if you fail to meet repayment obligations. Eligible collateral includes:

  • Multi-family apartments
  • Office buildings
  • Warehouses
  • Retail properties
  • Mixed-use properties
  • Self-storage properties

The application process for a commercial real estate equity line of credit involves several steps:

  1. Create a list of banks and lenders offering lines of credit for commercial properties.
  2. Study the terms and conditions, paying close attention to the eligibility criteria.
  3. Shortlist the preferred lenders.
  4. Collect the required documents, including tax returns, financial statements, property documents, insurance details, and personal tax returns for guarantors.
  5. Submit the completed application form and required documents, and be prepared to address any lender inquiries.

Lenders consider various factors when reviewing your application, including property value, equity, credit scores (business and personal), income level, business tenure, and other outstanding debts.

Pros and Cons of a Commercial Equity Line of Credit

Before making a decision, it's essential to weigh the pros and cons of a commercial equity line of credit:

Pros:

  • High degree of flexibility, allowing you to borrow as little or as much as you need.
  • Helps meet temporary working capital needs.
  • Access to funds for capitalizing on new business opportunities.
  • Lower interest rates compared to unsecured loans.

Cons:

  • Flexibility can come with costs such as appraisal fees and late payment fees.
  • Easy access to money may lead to hasty and unprofitable business decisions.
  • Failure to repay could negatively impact your credit score.

The Bottom Line

Commercial equity lines of credit offer property owners an excellent means of raising capital. The key advantage lies in their flexibility, allowing funds to be drawn only when needed and repaid as soon as additional liquidity becomes available. This approach helps keep interest costs low, as you only pay interest for the duration you utilize the funds. The accessibility of capital is particularly valuable when encountering working capital shortfalls or seizing promising investment opportunities.

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