Commercial real estate (CRE) is income-producing property that is used solely for business (rather than residential) purposes, such as retail malls, shopping centers, office buildings and complexes, and hotels. Financing – including the acquisition, development, and construction of these properties – is typically accomplished through commercial real estate loans: mortgages secured by liens on the commercial property.
Just as with home mortgages, banks and independent lenders are actively involved in making loans on commercial real estate. Also, insurance companies, pension funds, private investors and other sources, provide capital for commercial real estate.
Here, we take a look at commercial real estate loans: how they differ from residential loans, their characteristics and what lenders look for.
Individuals vs. Entities
While residential mortgages are typically made to individual borrowers, commercial real estate loans are often made to business entities (e.g., corporations, developers, limited partnerships, funds, and trusts). 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 rating, in which case the lender may require the principals or owners of the entity to guarantee the loan. This provides the lender with an individual (or group of individuals) with a credit history – and from whom they can recover in the event of loan default. If this type of guaranty is not required by the lender, and the property is the only means of recovery in the event of loan default, the debt is called a non-recourse loan, 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 residential mortgage product is the 30-year fixed-rate mortgage, but 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 loan, while shorter amortization periods generally entail larger monthly payments and lower total interest costs.
Residential loans are amortized 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 (or less) to 20 years, and the amortization period is often longer than the term of the loan. A lender, for example, might make a commercial loan for a term of seven years with an amortization period of 30 years. In this situation, 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 “balloon” payment of the entire remaining balance on the loan.
The length of the loan term and the amortization period will affect the rate the lender charges. Depending on the investor’s credit strength, these terms may be negotiable. In general, the longer the loan repayment schedule, the higher the interest rate.
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, including appraisal, legal, loan application, loan origination and/or survey fees. Some costs must be paid up front before the loan is approved (or rejected), while others apply annually.
A commercial real estate loan may have restrictions on prepayment, designed to preserve the lender’s anticipated yield on a loan. If the investors settle the debt before the loan’s maturity date, they will likely have to pay prepayment penalties. There are four primary types of “exit” penalties for paying off a loan early:
- Prepayment Penalty. This is the most basic prepayment penalty, calculated by multiplying the current outstanding balance by a specified prepayment penalty.
- Interest Guarantee. The lender is entitled to a specified amount of interest, even if the loan is paid off early. For example, a loan may have a 10% interest rate guaranteed for 60 months, with a 5% exit fee after that.
- Lockout. The borrower cannot pay off the loan before a specified period, such as a 5-year lockout.
- Defeasance. A substitution of collateral. Instead of paying cash to the lender, the borrower exchanges new collateral (usually U.S. Treasury securities) for the original loan collateral. High penalties can be attached to this method of paying off a loan. (For details, see “Defeasance Reduces Commercial Real Estate Fees.”)
Prepayment terms are identified in the loan documents and can be negotiated along with other loan terms in commercial real estate loans.
The Bottom Line
With commercial real estate, it is usually an investor (often a business entity) that purchases the property, leases out space and collects rent from the businesses that operate within the property. The investment is intended to be an income-producing property.
When evaluating commercial real estate loans, lenders consider the loan’s collateral; the creditworthiness of the entity (or principals/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.