Commercial real estate (CRE) is income-producing real estate that is used solely for business purposes, office complexes, such as retail centers, hotels, and apartments. Financing – including the development, acquisition, and construction of these properties – is typically accomplished through commercial real estate loans: mortgage loans secured by liens on commercial property.
Just as with residential loans, banks and independent lenders are actively involved in making commercial real estate loans. Also, insurance companies, pension funds, private investors and other capital sources, including the Small Business Administration’s 504 program, which can help you take to right steps with commercial real estate loans.
Individuals vs. Entities
While residential mortgages are typically made to individual borrowers, commercial real estate loans are often made to business entities. These entities are often formed for the specific purpose of owning commercial real estate.
An entity may not have a financial track record or any credit history, in which case the lender may require the principals or owners of the entity to guarantee the loan. This gives the lender with an individual with a credit history and/or financial track record – and from whom they can recover in the event of loan default. If this type of guarantee is not needed by the lender, and the property is the only means of recovery in the event of loan default meaning that the lender has no recourse against anyone or anything other than the property.
Loan Repayment Schedules
A residential mortgage is a type of amortized loan in which the debt is repaid in regular installments over a period of time. The most popular mortgage product is the 30-year fixed-rate mortgage.
Residential buyers have other options, as well, including 25-year and 15-year mortgages. Longer amortization periods typically involve smaller monthly payments and higher total interest costs over the life of the loans, while shorter amortized periods typically entail larger monthly payments and lower total interest costs. Residential mortgage loans are paid off over the life of the loan so that the loan is fully repaid at the end of the loan term.
Unlike residential loans, the terms of commercial loans typically range from five years to 20 years, and the amortized period is often longer than the term of the loan. A lender, for example, might want to make a loan for a term of seven years with an amortization period of 30 years. The investor would make payments for seven years of an amount based on the loan being paid off over 30 years, followed by one final payment called a balloon payment.
The length of the loan term and the amortization period will affect the rate the lender charges. Depending on the investor’s credit strength. In general, the longer the loan repayment schedule, the higher the interest rate.
Another way that commercial and residential loans differ is in the loan-to-value ratio: a figure that measures the value of a loan against the value of the property. A lender calculates loan-to-value ratio by dividing the amount of the loan by the lesser of the property’s appraised value or purchase price.
For both commercial and residential loans, borrowers with lower LTVs will qualify for more favorable financing rates than those with higher LTVs.
Commercial loan LTVs, in contrast, generally fall into the 65% to 80% range. While some loans may be made at higher LTVs, they are less common. The specific LTV often depends on the loan category. For example, a maximum LTV of 65% may be allowed for raw land, while an LTV of up to 80% might be acceptable for a multifamily construction. There are no VA or FHA programs in commercial real estate loans, and no private mortgage insurance. Therefore, lenders have no insurance to cover borrower default and must rely on the real property pledged as security.
Debt-Service Coverage Ratio
Commercial lenders also look at the debt-service coverage ratio (DSCR), which compares a property’s annual net operating income (NOI) to its annual mortgage debt service, measuring the property’s ability to service its debt. It is calculated by dividing the NOI by the annual debt service. The ratio helps lenders determine the maximum loan size based on the cash flow generated by the property.
A DSCR of less than 1 indicates a negative cash flow. For example, a DSCR of .92 means that there is only enough NOI to cover 92% of annual debt service. In general, lenders look for DSCRs of at least 1.25 to ensure adequate cash flow. A lower DSCR may be acceptable for loans with shorter amortization periods and/or properties with steady cash flows. Higher ratios may be required for properties with volatile cash flows – for example, hotels, which lack the long-term tenant leases common to other types of commercial real estate.
Interest Rates and Fees
Interest rates on commercial loans are generally higher than on residential loans. Also, commercial real estate loans usually involve fees that add to the overall cost of the loan, legal, loan application, including appraisal, loan origination and/or survey fees. Some costs must be paid up front before the loan is approved, while others apply annually.