What Are Commercial Real Estate Loans?

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By Dzhingarov

Commercial real estate loans are often misunderstood due to a lack of information about business owners. Such a loan is associated with CRE (commercial real estate), which is property that has the aim of producing income. Such property is only used for business.

Common examples of commercial real estate include shopping centers, office complexes, hotels and retail malls. Financing such properties is oftentimes accomplished through commercial real estate loans.

“A commercial real estate loan is a mortgage that is secured by commercial property lien. “

Both independent lenders and banks offer commercial real estate loans. There are also pension funds, insurance companies, private investors and various other entities that offer the capital needed for buying commercial real estate.

Understanding Commercial Real Estate Loans

Who Uses Commercial Real Estate Loans?

Commercial real estate loans are usually offered to business entities (like limited partnerships, developers, trusts, funds and corporations), as opposed to the residential mortgages, which are oftentimes made to the individual borrower. Usually, the entities are formed in order to own commercial real estate.

In the event that the business entity does not have a credit rating or a proven financial track record, lenders require owners or principals to offer loan guarantees. When the guaranty is not required and the only way for the lender to recover a possible loan default, we have a non-recourse commercial real estate loan. This means there is no way for the lender to get money back except the actual commercial property.

Repayment Schedules

Commercial real estate loans often vary in length between 5 and 20 years, with a longer amortization period. For instance, the commercial loan might be offered for a 7 years term with a 30 years amortization period. This means investors have to make payments for 7 years, with an amount that is based on a loan that would be fully paid in 30 years. A balloon payment covers the rest of the loan balance.

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To better understand this, let’s say we have a commercial loan of $1 million with an interest of 7%. Monthly payment is $6,653.02 over a duration of 7 years. Then, the balloon payment is the last one to cover what is left.

Amortization period and loan term length affects charges. Sometimes terms can be negotiated, based on the credit strength of the investor.

LTV (Loan-to-Value Ratios)

This figure measures loan value when compared with property value. The lender calculates this by dividing loan amount by either purchases price or appraised value (the lower amount is used to calculate). For instance, if we have an $80,000 loan and the property is $100,000, loan-to-value ratio is 80%.

Financing rates are more favorable when LTV is lower. This is because there is increased property equity. A higher LTV is allowed for residential mortgages, under specific rules. However, with commercial loan LTVs, we have LTV around 65% to 80%. Higher is possible but this situation is rare.

With commercial lending you do not have access to PHA or VA programs. There is also no possible use of private mortgage insurance.

DSCR (Debt-Service Coverage Ratio)

This ratio compares the mortgage debt service to the property’s NOI (annual net operating income). Practically, it measures the ability of the property to service the debt. NOI is divided by annual debt to calculate DSCR.

Debt-Service Coverage Ratio allows the lender to determine an appropriate maximum loan size as they take into account property cash flow. If DSCR is under 1, cash flow is negative. Commercial lenders usually want to see DSCR of over 1.25. However, if amortization period is lower or/and the property has a stable cash flow, lower DSCR can be accepted. If volatile cash flows are in place, a higher ratio is needed.

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Fees And Interest Rates

With commercial loans we have higher interest rates than with the residential loans. There are also fees that will increase overall loan cost. This includes fees like legal, loan origination, survey, appraisal and loan cost.

There are costs that have to be taken care of up front so the loan can be approved. Others will apply on an annual basis.

Prepayment Restrictions

The commercial real estate loans can have prepayment restrictions. They are designed to preserve the loan’s anticipated yield. When investors settle debts before maturity date, prepayment penalties apply. 4 types of such exit penalties exist:

  • Prepayment Penalty -The most basic type. It is calculated by taking the outstanding balance and multiplying it by a specific prepayment penalty.
  • Lockout – A barrower cannot pay off the commercial real estate loan before a specific period. For instance, it is common to see 5-year lockouts.
  • Interest Guarantee – A lender will receive a decided amount in interest, even if you pay off the loan early. As an example, the loan can have a guaranteed 10 percent interest rate for a period of 60 months, all with an exit fee of 5 percent.
  • Defeasance – This substitutes collateral. The lender exchanges some new collateral for the original collateral.

In the commercial real estate loan documents, you will see prepayment terms listed. They can also be negotiated with many other loan terms.

Final Thoughts

In commercial real estate, the investor buys a property, leases it out and then collects rent. This is an investment that has the main aim of producing income. As commercial real estate loans are evaluated, the lender thinks about collateral, creditworthiness, tax returns, financial statements, financial ratios and more.

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To sum up, commercial real estate loans are very useful but they are very serious. You need to be sure that you learn all that you can about the deal you sign.