Commercial real estate lending is different from home lending.
Commercial real estate (CRE) is income-producing property used for business (as opposed to residential) purposes only. Examples include retail malls, shopping centers, office and resort buildings, and hotels. Financing — including the purchase, development, and construction of these properties — is usually achieved by commercial real estate loans: mortgages backed by commercial real estate bonds.
Much as with home mortgages, banks and private lenders are actively engaged in producing commercial real estate loans. Insurance firms, pension funds, private investors and other outlets, including the U.S. Small Business Administration’s 504 Loan program, offer funds for commercial real estate.
Here, we look at commercial real estate loans, how they vary from residential loans, their features and what lenders are looking for.
Explaining Commercial Real Estate Loans
Individuals vs. Entities
Although residential mortgages are usually made to individual borrowers, commercial real estate loans are given to companies (e.g. businesses, developers, limited partnerships, funds, and trusts). Such companies are mostly created for the purpose of owning commercial immovables.
An entity may not have a financial track record or a credit rating, in which case the lender does request that the entity’s principal or owner guarantee the loan. This gives the lender a person (or group of individuals) with a credit history — and from which they will recover in case of default on the loan. If the lender does not allow this form of guarantee, and the property is the only means of restitution in case of default of the loan, the debt is considered a non-recourse loan, which implies that the lender has no recourse against anybody or something other than the property.
Loan Repayment Schedules
A residential mortgage is a form of amortized loan, where the debt is repaid over a period of time in regular installments. The most popular residential mortgage product is a 30-year fixed-rate mortgage but there are other options for residential buyers, including 25-year and 15-year mortgages. Longer amortization periods usually entail smaller monthly payments and higher overall interest costs over the lifetime of the loan while shorter amortization periods generally entail greater monthly payments and lower total interest costs.
Residential loans are amortized over the life of the loan, so that at the end of the loan term, the loan is fully repaid. For example, a borrower with a 5 percent $200,000 30-year fixed-rate mortgage would make 360 $1.073.64 monthly payments, after which the loan would be fully repaid.
In comparison to residential loans, the terms of commercial loans usually vary from five (or less) years to 20 years, and the amortization period is always longer than the loan duration. For example, a lender might make a commercial loan with an amortization period of 30 years, for a term of seven years. In this case, the borrower will make payments of a sum dependent on the loan being paid out for 30 years for seven years, followed by one more “balloon” payment of the entire balance remaining on the loan.
For example, a borrower with a commercial loan of $1 million at 7 percent will make monthly payments of $6,653.02 for seven years , followed by a final balloon payment of $918,127.64 that would completely pay off the loan.
The length of the loan term and the amortization duration determines the lender charges automatically. Those conditions can be negotiable, depending on the credit quality of the investor. In general, the longer the timeline for repaying the loan, the higher the rate of interest.
Another way in which commercial and residential loans differ is through the loan-to -value ratio (LTV), a figure which calculates a loan’s value against the property’s value. A lender calculates LTV by dividing the amount of the loan by the lower value or the purchase price of the land. For instance, the LTV will be 90 percent on a $90,000 loan on a $100,000 property ($90,000/$100,000=0.9, or 90 percent).
Borrowers with lower LTVs would qualify for more favorable financing terms on both commercial and residential loans than those with higher LTVs. The reason: They have more equity (or stake) in the land, which in the lender’s eyes is equivalent to less risk.
On some residential mortgages, large LTVs are allowed: up to 100% LTV is allowed on VA and USDA loans; up to 96.5% for FHA loans (loans insured by the Federal Housing Administration); and up to 95% for traditional loans (loans guaranteed by Fannie Mae or Freddie Mac).
In comparison, commercial loan LTVs typically fall within the range of 65 percent to 80 percent. Although some loans may be made on higher LTVs, they are less common. Often, the specific LTV depends on the category of loan. For example, for raw land a maximum LTV of 65 percent might be permitted, while for a multi-family development an LTV of up to 80 percent may be appropriate.
Commercial lending does not include VA or FHA schemes, so there is no private mortgage insurance. Therefore, the borrowers have no insurance to cover the default of the borrower and must rely on the pledged real estate as protection.
Note: Private mortgage insurance (PMI) is a type of insurance policy that protects lenders from the risk of default and foreclosure, enabling buyers who can not (or choose not to) make a significant down payment to obtain mortgage financing at affordable rates. Through allowing the borrower to buy insurance from a PMI firm, if a borrower purchases a residential property and puts down less than 20 percent, the lender will mitigate its risk.
Debt-Service Coverage Ratio
Commercial lenders are also looking at the debt-service coverage ratio (DSCR), which compares the annual net operating income (NOI) of a property to its annual mortgage debt service (including principal and interest), which measures the ability of the property to service its debt. The estimation is achieved by dividing the NOI by the annual debt service.
For example, a property with NOI $140,000 and annual mortgage debt service $100,000 would have a DSCR of 1.4 ($140,000/$100,000 = 1.4). The ratio lets lenders decide the actual size of the loan, based on the property’s cash flow.
A DSCR less than 1 indicates a negative cash balance. For example, a .92 DSCR means that there is only sufficient NOI to cover 92 percent of the annual debt service. Commercial borrowers typically aim for at least 1.25 DSCRs to ensure a sufficient cash flow.
For loans with shorter amortization periods and/or assets with stable cash flows, a lower DSCR can be appropriate. For properties with unpredictable cash flows, higher ratios might be needed — for example, hotels that lack the long-term (and therefore more predictable) rental leases common to other forms of commercial real estate.
Interest Rates And Fees
Interest rates are typically higher for industrial loans than for residential loans. Commercial real estate loans often contain fees that contribute to the total cost of the loan, including appraisal, legal, loan processing, loan origination and/or survey fees.
Some fees must be paid out in full before the loan is accepted (or dismissed), while others are assessed quarterly. For example, a loan could have a one-time loan origination fee of 1 percent, payable at the time of closing, and a one-quarter annual fee of one percent (0.25 percent) before full payment of the loan. For instance, a $1 million loan may require a loan origination fee of 1 percent equivalent to $10,000 to be charged up front, with a 0.25 percent fee of $2,500 paid annually (except interest).
A commercial real estate loan could have prepayment limits, intended to maintain the anticipated yield on a loan from the lender. If the investors settle the debt before the maturity date of the loan, they will probably have to pay penalties for the prepayment. There are four major forms of “exit” penalties to early payment of a loan:
- Penalty for Prepayment. That is the most basic penalty for prepayment, determined by multiplying the current unpaid balance by a given penalty for advance payments.
- Guaranteed interest. The lender is entitled to a specified interest amount, even if the loan is paid out early. For example, a loan may have a fixed interest rate of 10 percent for 60 months , followed by a 5 percent withdrawal fee.
- Lockout. The borrower can not pay off the loan before a specified period, like a lockout for five years.
- Defeasance. Instead of collateral. Rather than paying the lender cash, the borrower swaps new collateral (usually U.S. Treasury securities) for the initial collateral loan. This can reduce fees, but high penalties can be attached to this loan payment method.
The terms of prepayment are specified in the loan documents and can be negotiated in commercial real estate loans with other terms of the loan.
The Bottom Line
An investor (often a business entity) buys the property with commercial real estate, rents out space, and collects rent from the businesses operating within the property. The investment is intended to be a real estate that generates revenue.
When evaluating commercial real estate loans, lenders consider collateral for the loan, the creditworthiness of the entity (or principal/owners), including three to five years of financial statements and income tax returns, and financial ratios, such as the loan-to-value ratio and the debt-service coverage ratio.