Commercial Real Estate Loans

Commercial real estate loans provide financing for investment properties. Loans are available for multifamily residential, commercial (e.g. office, retail), industrial (e.g. manufacturing, distribution), and other investment properties.

These loan products can be used to acquire new properties, renovate income-producing properties, improve properties, restructure existing debt, or for other purposes.

Lenders evaluate properties and investors on a case-by-case basis to determine whether the lender is able to extend the requested commercial property financing.

The criteria that lenders consider are largely specific to investment properties, but the process of submitting an application, going through underwriting, and hopefully securing financing is much like any other loan process. The requested information and loan features are simply different (see What You Need to Know).

Commercial real estate loans work much like personal residential loans in principle, but there are substantial differences in the loan amount, loan features, repayment schedule, and evaluated criteria.

Whereas a personal mortgage normally requires certain income and employment history, a commercial property loan weighs recurring revenue and some other business-related factors heavily. Calculations such as DSCR, cap rate, and NOI are much more common. So too are non-recourse, personal guaranty, and similar clauses.

The common 30-year fixed-rate mortgage is still available for commercial property, but it’s used much less frequently. Borrowers more often get shorter-term loans that may have longer amortization schedules, balloon payments, prepayment penalties, and other features that are infrequently found in residential mortgages.

Individuals vs. Entities

A large difference between residential loans and commercial real estate loans is simply who the borrower is. Commercial property loans aren’t offered to individuals, but rather limited liability corporations, limited liability partnerships, general partnerships, S corporations, and C corporations.

Although individuals might technically secure financing for a small investment property (e.g. duplex) as a sole proprietor, this generally isn’t recommended and usually isn’t considered a true commercial property loan. Commercial property financing is usually for LLCs, LLPs, GPs, S Corps, and C Corps that have larger properties (e.g. minimum 5-unit multifamilies, offices, stores, etc.).

Commercial real estate loans can come with floating (variable) interest rates, fixed interest rates, or floating-to-fixed rates. Floating rates change over the course of a loan as market rates adjust, often changing once per year. Fixed rates are set for the duration of the loan.

Lenders consider the property, borrower, market rates, and other factors when setting interest rates. Government-backed loan programs sometimes have slightly lower interest rates.

When calculating repayment, the interest rate is applied to the full amortization schedule rather than only the loan term.

Commercial Loan Calculator

Since a loan’s repayment schedule is impacted by the loan’s term, amortization, balance, interest rate structure, and interest rate, manually calculating repayment is cumbersome. A loan calculator makes it easy to see how repayment changes as the interest rate and other factors change, though.

Importantly, investors should use a commercial loan calculator rather than a residential mortgage calculator. Residential mortgage calculators won’t adequately account for the various factors that affect commercial loan repayment schedules.

The requirements and features of commercial real estate loans are somewhat particular to this category of loan. Here are the specific terms to know when applying for this type of funding.

Repayment Schedule

Commercial real estate loan repayment schedules are based on term and amortization, and these frequently are different durations. The term is how long regular payments will be made. The amortization is the duration that’s used to calculate those regular payments.

For example, a commercial property loan might have a 10-year term and 30-year amortization. The regular payments (usually monthly) would be calculated as if the loan would take 30 years to pay off. The payments would only be made for 10 years, at which time a large payment would be required to clear the remaining balance of the loan.

Because term is often shorter than amortization, balloon payments are common with commercial property loans. Investors frequently manage balloon payments by refinancing or selling, but simply paying them is, of course, acceptable.

Loan-to-value

Loan-to-value ratios measure the balance of a commercial property loan against the value of a financed property. Loan programs have maximum allowed LTVs so that lenders don’t assume too much risk.

Loan-to-value is calculated as follows: LTV = Loan Balance / Property Value

A maximum allowed LTV of 80% is common, but some programs have different allowed maximums. Non-guaranteed programs might have lower LTV requirements. Guaranteed programs might have slightly higher LTV allowances.

Debt-Service Coverage (DSCR)

Debt-service coverage ratios measure a property’s income against the property’s debt. Lenders use DSCR to evaluate whether a property has enough income to service its monthly debt payments.

Debt-service coverage ratio is calculated as follows: DSCR = NOI / Debt Service

Net operating income encompasses a property’s revenues less its operating expenses. Debt service encompasses the interest payments and principal repaying, often of all loans on the property.

Prepayment Penalty

Prepayment penalties are charged when a commercial property loan is fully paid before the maturation date. Lenders use prepayment penalties to ensure at least a portion of their expected return on a loan. Penalties are common on most types of commercial real estate loans.

Prepayment penalties can be structured a number of different ways:

• Lockout Period: Doesn’t allow early repayment for the duration of the period
• Fixed Fee: Assesses a fixed percentage fee if fully repaid early
• Step Down: Assesses a percentage fee that decreases with time
• Yield Maintenance: Assesses a fee based on the expected interest a lender loses
• Defeasance: Assesses a fee in the form of government-based securities

Cap Rate

Cap rates measure the expected annual return that a property should generate. The rate represents the annual expected return that an all-cash investment would yield. Lenders use the rate to evaluate the financial health of an investment property.

Cap rate is calculated as follows: NOI / Property Value

Net operating income encompasses a property’s revenues less its operating expenses.

Net Operating Income

Net operating income encompasses a property’s revenues less its operating expenses.

Net operating income is calculated as follows: RR – OE

Recurring revenue can stem from rental income, parking fees, service charges, vending machines, or any other regularly recurring form of revenue.

Operating expenses encompass repairs, maintenance, taxes, insurance, utilities, management fees, and other recurring expenses that are necessary to operate a property. Improvements aren’t part of operating expenses.

Loan-to-cost (LTC)

Loan to cost ratios measure the cost of financing a property against the cost of building it. The ratio is specific to construction, and not used for acquisition or refinancing. Lenders consider LTC when calculating the amount of equity that must be retained during construction.

LTC is calculated as follows: LTC = Loan Amount / Construction Cost

Preparing for a commercial real estate loan requires having documents about both the property and your business in order.

You should have property value, revenue, construction costs (if building or renovating), tenant (if multifamily), and other relevant information available. While you ought to calculate LTV, DSCR, cap rate, and other ratios yourself, a lender will likely review each of these with you. You’ll also need any information that’s necessary to show a property qualifies for a specific program.

You should also have business data ready. Be prepared with ownership, portfolio, revenue, expense, and other relevant information. Lenders will consider your application in light of your business’s past performance, current portfolio, cash flow, credit, and other factors.