Commercial Real Estate Loans: A Guide to Real Estate Lending
A commercial real estate loan is used to finance income-producing property such as shopping centers, office complexes, hotels, and retail malls. One or multiple phases of the real estate project’s lifecycle— from acquisition to development and construction — may be financed with commercial real estate loans. The nuances of these loans may vary based on the type of project, the project life cycle, and more.
Entities Versus Individuals
To understand commercial real estate loans, it’s important to know the differences between entities and individuals. In the context of commercial real estate, loans to finance properties are generally made to an entity, such as a trust, fund, limited partnership, or corporation rather than individual people.
In fact, it’s fairly common for developers and investors to create an entity (or multiple entities) through which they own a portfolio of properties. They may even create new entities for each individual project.
The reason they do this is to limit their liability and to reduce their tax burden. Limiting the liability of any single individual is especially important in commercial real estate because, generally, you’re working with properties that require a significant amount of capital to acquire or develop. If there’s no limit to your liability in a large real estate deal, your financial risk could easily climb into the millions.
All that said, even if the loan is technically made to an entity, the lender may also require that someone — usually the entity owners — guarantee all or a portion of the loan. This means that, if the entity fails to pay back its loan, the individual(s) who guaranteed the loan is required to pay back the debt.
If the lender doesn’t require a guarantee, that means it’s a non-recourse loan. With a non-recourse loan, no individual or entity is liable for anything beyond the loan collateral, which is generally the property. While it’s usually a good idea to use some type of entity for commercial real estate loans, which one you use depends on your situation.
Schedule for Repayment of Loans
Regardless of the type of real estate business loan you’re evaluating, one of the most important parts of that loan is its repayment schedule.
In commercial real estate, there are several different types of loans including construction loans, bridge loans, hard money loans, permanent loans, and SBA loans.
Each of these different types of loans comes with different repayment schedules. For example, a permanent loan is generally paid back over a period of 20 to 25 years while a bridge loan must be paid back in one to two years.
These repayment schedules have significant implications for real estate businesses because of their impact on cash flow. This makes it critical for anyone considering using a commercial real estate loan to understand how their repayment schedule aligns with their project.
For example, a bridge loan wouldn’t be a good fit if you’re trying to finance the purchase of a shopping mall because you’ll have to pay it back within one to two years. However, that bridge loan could be a good option if you need to finance a one to two-year real estate project that, once completed, will generate enough revenue to pay back the bridge loan.
Another key distinction of a commercial real estate loan’s schedule for repayment is how the loan is amortized.
To understand this distinction, it’s helpful to think about home mortgages. With a typical home mortgage, you’d take out a 30, 25 or 15-year mortgage and the loan would be amortized over the life of the loan. That means you repay the loan in regular monthly installments for however long the term of your loan is. At the end of the term, your loan would be paid off.
With commercial real estate loans, it’s different. Instead of spreading out the repayment schedule over the entire term of the loan, commercial real estate lenders amortize the loan over a longer period than the loan’s term. At the end of the loan’s term, the borrower owes a balloon payment to pay off the balance of the loan.
For example, you might take out a commercial real estate loan with a term of 10 years and an amortization period of 25 years. For 10 years, you’d make payments that are based on the entire loan being paid back in 25 years. Then, after 10 years had passed, you’d owe a payment for the balance of the loan.
About Loan to Value Ratios
The Loan-To-Value (LTV) ratio is one of the first ratios that commercial real estate lenders look at when they’re evaluating whether to approve a loan request. As important as this ratio is, it’s also fairly simple. The LTV is the amount of the loan divided by the market value of the property.
This is an important ratio to understand because many lenders use it as a quick reference as to whether or not they can approve your loan. Generally speaking, lenders prefer to target LTV ratios of less than 80 percent, though it’s possible to get a commercial real estate loan with a higher LTV ratio.
The reason LTV is so critical is that it gives the lender an understanding of the risk level of the loan. The larger the loan amount is relative to the value of the property, the greater the risk and vice versa.
About Debt Service Coverage Ratios
The Debt Service Coverage Ratio (DSCR) is another significant measure by which commercial lenders evaluate loans. This ratio is equal to a property’s annual net operating income divided by its annual debt service, including principal and interest payments on the loan. In other words, the DSCR looks at how much money the property will generate after expenses compared to how much the loan is going to cost each month.
If the loan payments are going to be higher than the income the property brings in, the DSCR will be less than one, and the lender is unlikely to approve the loan. It’s not uncommon for loans to be denied solely because of an insufficient DSCR ratio even if the LTV ratio is favorable. However, it may be possible to work with a lender to reduce the amount of a loan until the DSCR ratio improves enough to meet the lender’s threshold for approval.
About Interest Rates, Fees, and Prepayments
Just as with any other type of loan, commercial real estate loans come with various interest rates, fees, and prepayment terms.
Generally speaking, interest rates on these types of loans are relatively high. This is due to many factors, including the risk level of the project being financed as well as the financial history of the borrower. Keep in mind, though, that interest rates on commercial real estate loans vary widely depending on the specific type of loan. For example, bridge loans will have much higher interest rates than permanent loans, assuming all else is equal.
Compared to a traditional residential real estate loan, there are generally more fees you’ll have to pay on a commercial real estate loan. Again, this is partly due to the heightened risk of these types of loans but it’s also because commercial real estate loans are more complicated to service. There may be fees associated with appraisals, land surveys, applications, and loan origination that you wouldn’t see on other types of loans.
Although it might seem counterintuitive, lenders generally don’t want you to pay off your loan early. This is especially true for commercial real estate lenders because, by prepaying your loan, you reduce their profit on the loan by avoiding interest payments. To prevent this, real estate business lenders use a few different types of prepayment penalties.
The simplest type of penalty is a prepayment penalty based on the loan balance at the time of prepayment multiplied by a pre-set penalty rate.
Another type is the interest guarantee which will require the borrower to reimburse the lender for the interest payment they lost as a result of prepayment, plus an exit fee.
The most severe type of prepayment penalty on a commercial real estate loan is a defeasance, in which the borrower must purchase treasury bonds to repay the loan and guarantee a given rate of return to the lender.
If you’re considering a commercial real estate loan, it’s critical to understand just how different it is from a traditional business loan. From the process of applying and getting your application approved to structuring the loan and paying it off, almost everything’s different. Also, there will be slightly different nuances depending on the type of real estate business loan.
That said, the concepts of traditional financing still apply. Lenders generally want to reduce their risk and maximize their return. So, if you have a strong fundamental understanding of finance, entering the world of commercial real estate lending should be a smooth transition for you.
Of course, it’ll help to have a partner along your journey. For that, you can rely on Fora Financial. Sign up for our email list and you’ll receive regular updates with tips, tools, and strategies for running a successful small business.
Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.