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This is the first post of the Basics of Commercial Real Estate Loans blog series. The goal of this series is to provide you with a basic understanding of commercial real estate (CRE) loans so you are better equipped to invest in commercial real estate. At JP Acquisitions, we invest solely in multifamily real estate (apartment buildings with 5+ units) and thus this blog series will primarily use examples from our experience in the multifamily industry.
When it comes to investing in commercial real estate, you have to understand how commercial financing works. The entire real estate market, and really all of finance, runs on the ability of people and companies to borrow money. Additionally, different types of financing (otherwise known as financing products) and their inner workings have different levels of risk and return which are necessary to know so you can best structure or analyze a real estate deal/project. Thus, understanding commercial real estate financing is an absolutely critical piece of being a profitable and knowledgeable investor. That being said, let’s jump into this post!
- Note 1 – The definitions of the technical terms in any of our posts can be found in the glossary section of our website.
- Note 2 – The examples in this blog post series are simplified for ease of understanding.
Residential Loans vs. Commercial Real Estate Loans
Before really getting into the weeds of CRE loans, it’s a good idea to understand what makes residential (i.e., single-family) and CRE loans different. It’s easy for someone to confuse the two different loans as having the same structure. In reality, that’s not true and I’ve outlined the differences below for you in a easy to digest way:
Residential Loans:
- Residential mortgages are typically made to individual borrowers.
- Residential mortgages are amortized loans in which the debt is repaid in regular installments over a period of time. While there are interest-only residential mortgages, they’re less common. The most popular residential mortgage product is the 30-year fixed-rate mortgage.
- There are loan products for residential loans where the lender may finance 100% of the property, such as USDA or VA loans.
Commercial Real Estate Loans:
- Commercial real estate loans are usually made to business entities (corporations, developers, limited partnerships, funds, and trusts).
- Commercial loans typically range from less than 5 years to upwards of 20 years, with the amortization period often longer than the term of the loan. In other words, the monthly loan payments are usually structured as if the loan is going to be paid off in 30 years, but the term is usually lower meaning a refinance or sale will have to occur then.
- Commercial loan loan-to-value ratios generally fall into the 65% to 80% range. Also, interest-only periods are much more common than residential loans.
Recourse vs. Non-recourse
As stated earlier, while residential loans are usually made to individual borrowers, residential loans are typically made to business entities. This is the case because people often buy commercial properties with entities such as limited liability companies (LLCs) to protect themselves from experiencing significant losses. You can read this blog post to read further into why CRE is typically purchased using an LLC.
Having this understanding, we can now talk about the terms recourse and non-recourse. In the event that the entity trying tot take out the loan doesn’t have a strong enough financial track record or credit rating, the lender may require the principals or owners of the entitiy to guarantee the loan. When there is a personal guarantee on a loan, the lender can cover a portion or all of their loan by seizing the asset and collateral (i.e., the property) and the individual(s) assets. When their is a personal guarantee for a property, that is known as a recourse loan. A non-recourse loan on the other hand is when the bank can only seize the property in the event of default, leaving the assets of the owners safe from being seized. It’s important to note that lenders require significant evidence from the borrower(s) before providing a non-recourse loan so they can limit their risk exposure. Some requirements for non-recourse loans include the following and vary by lender:
- Type of property and class: Newer properties in established markets are more likely to qualify for a non-recourse loan/ For example, a Class A multifamily property in Chicago’s Gold Coast neighborhood.
- Experience of the borrower: The more successful deals that the borrower operates or went full circle (bought, operated, and sold the asset successfully), the higher the likelihood that they will qualify for a non-recourse loan. A good rule of thumb is that if the sponsor has operated at least 3 properties for several years in a given market and is looking to take on a non-recourse loan for a similar deal, they’ll qualify.
- Property Income: If the property has historically produced a significant amount of income in comparison to its expenses, that’s a good sign.
- The requested amount of leverage: The lower the leverage the borrower is requesting in comparison to the value of the property, the higher the likelihood of obtaining a non-recourse loan.
What’s important to remember is that banks and financial institutions are not in the business of operating properties, no matter how good a given asset might be. Banks are in the business of making loans and earning income from interest rate spreads and fees associated with those loans. More so, banks are very risk-averse meaning they want to take on as little risk as possible. Non-recourse loans are more of a win for the borrower as opposed to the bank because they have less skin in the game so to speak (i.e., they’re less invested in the deal).
Loan Repayment Terms & Prepayment Penalites
It could be argued that the biggest difference between residential and CRE loans is the repayment term. Residential loans are amortized over the life of the loan so that the loan is fully repaid at the end of the loan term. As stated earlier, the most popular residential mortgage product is the 30-year fixed-rate mortgage, but some people opt for a 20 or 25-year mortgage to pay off their property faster. On the other hand, CRE 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 5 years with an amortization period of 30 years. In this case, the investor would make payments for 5 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.
For example, let’s say that you take out a $750K loan on a $1M multifamily property at a 7% interest with a term of 5 years and amortized over 30 years. The monthly interest payments would be ~$4.4K and the principal payments would be ~$600. The final “balloon” payment at the end of year 5 would be ~$706K. At the end of year 5 you have a few options, either sell the property and pay off the balloon payment or refinance and get a new loan.
The length of the loan term and the amortization period affect the rate the lender charges. The loan terms may be negotiable depending on the investor’s credit and financial strength. In general, the longer the loan repayment schedule, the higher the interest rate.
In the event that a borrower pays off their CRE loan before the end of the term, lenders charge prepayment fees. These penalties are designed to compensate lenders for the interest income they would have earned if the loan had been repaid according to the original terms. Prepayment penalties are common in commercial real estate financing and can vary in structure and severity. This post would be incredibly long if we dove into the 3 types of prepayment penalties and thus I’ll direct you to this post to read more about the types of penalties (read the following terms: step-down, yield maintenance, and defeasance).
Important Loan Ratios
Loan-to-Value (LTV): The LTV ratio is a financial metric used by lenders when sizing CRE loans. It provides a measure of the relationship between the amount of the loan and the appraised value of the property being financed. Remember, the bank wants to make sure their loan is sized appropriately and thus they will require an appraisal to be completed to understand the value of the property. Nevertheless, LTV is expressed as a percentage and is a key factor considered by lenders when evaluating the risk associated with a commercial real estate loan.
The formula for calculating the Loan-to-Value ratio is as follows:
Loan-to-Cost (LTC): The LTC ratio is another important financial metric in the context of commercial real estate loans. Similar to the Loan-to-Value (LTV) ratio, the LTC ratio provides a measure of the relationship between the loan amount and the total cost of a commercial real estate project. It is particularly relevant in situations where the borrower is seeking financing for the development or construction of a new property or a substantial renovation of an existing one.
For example, one investor could invest in a $1M property and get a 75% LTV loan which equals $750K (75% x $1M) and have to pay a $250K down payment. Assuming the same details, but let’s say the same investor gets a 75% LTC loan and wants to put $200K in renovations. The loan amount in this case would equal $900M (($1M property + $200K renovations) * 75%).
The formula for calculating the Loan-to-Cost ratio is as follows:
Debt Service Coverage Ratio (DSCR): The DSCR is a key financial metric used in CRE loans to assess the ability of a property to generate enough income to cover its debt obligations. Lenders use the DSCR as a measure of risk when evaluating the feasibility of providing financing for a commercial property. The ratio is crucial for determining whether a property’s income is sufficient to meet its debt service, which includes principal and interest payments on the loan. Typically, lenders want to see that a property has at least a DSCR of 1.25 before providing a loan on it.
The formula for calculating the Debt Service Coverage Ratio is as follows:
Conclusion
Navigating the world of commercial real estate loans requires a solid understanding of the various loan types, key factors, and the application process. As with any financial decision, thorough research and consultation with financial professionals are crucial to making informed choices. Whether you’re a seasoned investor or a newcomer to the commercial real estate market, a well-structured loan can be a powerful tool for unlocking the potential of your real estate investments. If you invest in syndications, understanding the loan structure helps to better perceive the risk associated with the project at hand. I trust that this post has provided you with a solid foundation which we will build off of in the next post of this blog series!
If you have any questions regarding the terms and concepts in this post or previous ones, please reach out to either me (tedi.nati@jpacq.com) or someone on our team so we can help explain further. If you’re interested in investing with us at JP Acquisitions, you can contact us via our contact form, by emailing a member of our team, messaging us on LinkedIn, or signing up for our investor portal to set up a meeting.
As always, I hope you enjoyed reading this post as much as I have writing it. Best of luck!
