10 UNITS OF 3 BEDROOM APARTMENT ALL EN SUITE FOR LEASE.
WATER TREATMENT PLANT
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UNDERGROUND DIESEL TANK
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FIRE FIGHTING SYSTEM ON EACH FLOORS LOBBY
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.
Real estate is property made up of land and the buildings on it, as well as the natural resources of the land, including uncultivated flora and fauna, farmed crops and livestock, water and mineral deposits. Although media often refers to the “real estate market,” from the perspective of residential living, real estate can be grouped into three broad categories based on its use: residential, commercial and industrial. Examples of residential real estate include undeveloped land, houses, condominiums and town houses; examples of commercial real estate are office buildings, warehouses and retail store buildings; and examples of industrial real estate include factories, mines and farms.
BREAKING DOWN ‘Real Estate’
Real estate is a special instance of real property. Real property, a broader term, includes land, buildings and other improvements – plus the rights of use and enjoyment of that land and all its improvements. Renters and leaseholders may have rights to inhabit land or buildings that are considered a part of their personal estate, but are not considered real estate.
Personal property includes intangible assets like stocks, bonds and other investments; it also includes chattels, like computers, furniture and clothes, as well as fixtures like a dishwasher, even if you are renting a home (provided you bought and installed it with the lessor’s permission).
Residential Real Estate and Home Ownership
Home ownership, also known as owner-occupancy, is the most common type of real estate investment in the United States. According to the National Multifamily Housing Council, roughly two-thirds of residents own their home. Often, they have financed the purchase by taking out a particular type of loan known as a mortgage, in which the property acts as collateral for the debt.
Individuals shopping for a mortgage to invest in real estate in the form of an owner-occupied home are faced with a variety of options. Mortgages can either be fixed-rate or variable-rate. Fixed-rate mortgages generally have higher interest rates than variable-rate mortgages, which can make them more expensive in the short run. Fixed-rate loans cost more in the short-term because they are protected from future interest rate increases (see also payment shock).
Banks publish amortization schedules that show how much of a borrower’s monthly payments go to paying off interest versus how much goes to paying off the principal of the loan. Balloon loans are mortgages that don’t fully amortize over time: The borrower pays interest for a set period, five years for example, and then must pay the remainder of the loan in a balloon payment at the end of the term.
Also, mortgages can come with heavy costs, including transaction fees and taxes, which are often rolled into the loan itself. Once potential homeowners have proven their eligibility and secured a mortgage from a bank or other lender, they must complete an additional set of steps to make sure the property is legally for sale and in good condition.
Commercial Real Estate
Commercial real estate is used for commerce and includes anything from strip malls and free-standing restaurants to office buildings and skyscrapers. It is often distinguished from industrial real estate, which is practical space used in the manufacturing of products. Buying or leasing real estate for commercial purposes is very different from buying a home or even buying residential real estate as an investment. Commercial leases are generally longer than residential leases. Commercial real estate returns are based on their profitability per square foot, unlike structures intended to be private residences. Moreover, lenders may require more money for a down payment on a mortgage for commercial real estate than for a residence.
Unlike other investments, real estate is dramatically affected by its surroundings and immediate geographic area; hence the well-known real-estate maxim “location, location, location.” With the exception of a severe national recession or depression, residential real estate values in particular are affected primarily by local factors, such as the area’s employment rate, economy, crime rates, transportation facilities, quality of schools and other municipal services, and property taxes.
There are key differences in residential and commercial real estate investments. On the one hand, residential real estate is usually less expensive and smaller than commercial real estate and so it is more affordable for the small investor.
On the other hand, commercial real estate is often more valuable per square foot and its leases are longer, which theoretically ensures a more predictable income stream. With greater revenue comes greater responsibility; however, commercial rental real estate is more heavily regulated than residential real estate and these regulations can differ not only from country to country and state by state, but also by county and city. Even within cities, zoning regulations add a layer of unwanted complexity to commercial real estate investments.
There is also increased risk of tenant turnover in commercial rental agreements. If the lessee’s business model is bad, their product is unattractive or they are simply poor managers, they might declare bankruptcy, which can abruptly stop expensive real estate from generating revenue. Moreover, just as land can appreciate in value, it can also depreciate. Once-hot retail locations have been known to decay into rotten shopping centers and dead malls.
How to Invest in Real Estate
One can invest in real estate directly by buying actual properties or parcels of land; or indirectly, by buying shares in real estate investment trusts (REITs) or mortgage-backed securities (MBS).
Investing directly in real estate results in profits (or losses) through two avenues, which haven’t changed in centuries:
revenue from rent or leases
appreciation of the real estate’s value
Of the two avenues above, appreciation is the most common. It’s achieved through different means, but the increase in a property’s value isn’t actually realized until the owner sells it outright, or refinances his mortgage on it. Raw and undeveloped land, like the territory right outside a city’s borders, offers the biggest potential for construction, enhancement and profit. Appreciation can also come from discovering valuable materials on a plot of land, like striking oil. Or, simply by a rise in the area around the land you own.
As a neighborhood grows and develops, property values tend to climb. The gentrification of urban neighborhoods in some American cities over the last few decades has often resulted in a dramatic increase in real estate prices. Scarcity can play a factor, too. If a lot is the last of its size or kind in a prestigious area – or one in which such lots rarely become available – it obviously gains in marketability.
Income from real estate comes in many forms. The biggest generator is the rent paid on land already developed into residential or commercial properties. But companies will pay royalties for discoveries on raw land, or they may pay to build structures on it, like cell towers or pipelines. Income can also come from the indirect investments, like REITS, which trade like stocks, with real estate as their underlying security. In a REIT, the owner of multiple properties sells shares to investors and passes along rental income in the form of distributions.