The Structure of Commercial Real Estate Loans
Commercial real estate loans help business owners or investors finance the purchase of commercial property. Commercial property is defined as any income-producing property used solely for business purposes, such as industrial warehouses, office buildings, multi-family complexes, retail strip malls, and more. Financing is an essential part of both an investor’s portfolio and a business owner’s operations.
This three-part series on commercial real estate lending provides a fundamental understanding of the process and commonly used products within the commercial lending realm. This series is not exhaustive, nor is it meant to provide financial advice. However, we aim to provide a basic understanding of the lending options available to you as you seek to acquire commercial real estate.
This series will discuss the following topics:
- Structure of Commercial Real Estate Loans
- How to Get a Commercial Real Estate Loan
- Types of Commercial Real Estate Loans
Seeking a commercial real estate loan can seem daunting. Even though residential mortgages have similar aspects, the actual terms and structure of the loans are much different for commercial properties. In Part 1 of this series, we’ll be focusing primarily on the general structure of a commercial real estate loan. Most of these terms will be from the standpoint of a traditional bank loan for the purchase of real property. A traditional bank loan is one of the most common types of commercial loans, however, we also discuss other common lending options in Part III of this series – Types of Commercial Real Estate Loans.
Commercial Real Estate Lending Terms
Regardless of the specific loan, bank financing for commercial real estate involves the following terms and structure in varying degress (the numbers provided here reflect industry standards and averages):
Borrower – the borrower is the individual or entity seeking the loan. This can be an individual, a group of two or more people (co-borrowers), or even a legal entity. It is not uncommon to see an LLC or a family trust seeking financing for commercial property. Whatever the case, the borrower is the entity that will (most often) hold title to the property.
Personal Guarantor – The guarantor is the one guaranteeing that the loan will be paid back. Oftentimes this means pledging private assets of the individual or entity that is acting as guarantor. There can be more than one guarantor. Regardless, the guarantor(s) are responsible for paying the loan back if the borrower defaults.
Many times the borrower and guarantor are the same. If an entity is the one obtaining the property, the owners of the entity will often be the personal guarantors for the loan. Banks will look at the guarantor’s other assets or income for additional security on the loan repayment.
It is industry standard for a bank to require a personal guarantee from every owner that has 20% or more ownership of the business or entity.
Terms of the Loan
In residential real estate, 30-year mortgages are the norm. This is the rare exception in commercial real estate.
The typical length of a commercial real estate loan is 10-15 years, amortized over a longer period (20-30 years), with a balloon payment at the end of the loan. For instance, for a 10-year loan, amortized over 30 years, the interest would be factored over a 30-year period, but the payments would be factored into a 10-year payment plan, with a large sum due at the end of the ten years for loan payoff (balloon payment).
Rates for Commercial Loans
Rates in commercial lending also differ considerably from residential loans. A 30-year fixed rate is normal for residential mortgages. In commercial financing, a 30-year fixed rate would come with a much higher interest rate and would be quite uncommon to find. The norm is a 5-year fixed rate, with a rate reset at the end of year 5.
Rates can vary from loan to loan, as they are based upon a variety of factors: the type of property, owner-occupied or non-owner occupied, the type of loan, the LTV ratio (more on this later), the credit of the borrower, etc.
In the commercial banking industry, CRE rates are generally based upon an index plus a spread. The most common indexes used are the 5 Yr. CMT, Wall Street Journal Prime Rate, and the LIBOR. The index rates do not portray the final rate. Indexes provide the initial rate; then the spread is added to that rate to obtain the actual rate of the loan. For example, if your loan terms state the rate as the 5-year CMT + 3.5%, and the CMT is .85%, your rate would be 4.35% (.85% + 3.5%).
Two other important definitions associated with rates are the floor rate (the lowest a rate can be) and the ceiling rate of the loan (the highest the rate can be). The floor rate is usually the initial rate (based upon the index). The ceiling rate is usually the highest the rate can legally be as determined by the federal government.
Loan To Value
The Loan to Value (LTV) is one of the most important factors banks use to determine how much they will lend on a property. This figure is produced when dividing the amount of the loan by the value of the property, expressed as a percentage.
For instance, if a property was valued at $2,000,000 and the loan is $1,400,000, the LTV would be 70%.
The LTV maximum for a traditional bank loan on a property that is owner-occupied is typically around 75-80%. For a non-owner-occupied property, the maximum is 65-70% LTV. For SBA loans, a higher LTV is typically allowed.
Loan to Cost – Loan to cost ratio is also used for determining the stability of a financing proposition. This is most often used for construction loans (discussed more in Part III) to compare the financing of the project with the cost of building the project.
There are several fees associated with a CRE loan. Naming them all here would be far too lengthy. However, the ones listed below are the most common fees in commercial lending.
Loan Fee – This is the fee paid directly to the bank and is usually a percentage of the loan amount. The typical percentage is .5% – 1%.
Documentation Fee – This is also paid to the bank, but it is a set price rather than a percentage. Documentation fees are typically between $250 – $500 but can reach several thousand dollars, depending on the complexity of the property and the deal. These fees are for the preparation of documents for the loan.
Appraisal Fee – Appraisals in commercial real estate will usually shock first-time purchasers. They range anywhere from $2,500 – $5,000. However, these are much more in-depth than the traditional residential appraisal. The 100-200 page document provided is usually exhaustive, providing quality insight into the subject property.
A newly amended federal rule filed in 2018 called “Real Estate Appraisals”, allows for all transactions under $500,000 to forego a 3rd-party appraisal. In these situations, banks will often do their own internal valuation.
Title Insurance Fees – Title Insurance ensures that the title to a property is held “free and clear” and will transfer without issues to the new owner. A Title Report involves a records search for any existing liens/loans on the property, easements on the property, unpaid taxes or service fees on the property, and other property rights (mineral rights, water rights, etc.) These fees vary based upon the type and amount of insurance required by the bank.
Escrow Fees – The title company is usually the one that also handles the loan closing. They charge a processing fee for the paperwork involved, disbursing payments, and ensuring the transaction goes smoothly. These fees vary depending on loan size, complexity and work involved.
Environmental Fee – An environmental screen is common for property acquisition, but depending on the subject property, can be as simple as an environmental questionnaire provided by the bank. These screens help identify any potential environmental concerns of which the buyer and the bank need to be aware. Environmental cleanup can be extremely costly, and banks want to ensure prospective buyers are aware of all potential issues. The following fees are associated with the type of environmental assessment required:
Environmental Bank Questionnaire (Free) – usually a simple online form that asks a few questions about the property.
Environmental Desktop Report ($500 – $1,000) – this report searches online through a variety of databases and historical records to determine if the property is at high risk or low risk for environmental concerns. No site visit is including in this type of report. Depending on the findings, the next stage of environmental assessment may be necessary, which is a Phase I ESA.
Phase I ESA ($2,000 – $3,000) – this involves an actual site visit by an environmental engineer. The engineer will also search historical records and databases to provide a full assessment of the property.
Phase II & III ESA (from $5,000 to well over $100,000) – If a Phase I ESA report determines the need for more investigation into the property, a Phase II or Phase III report will be required. This involves actual site digging and soil sampling. Depending on the site and the complexity of environmental concerns, this can get quite costly.
As mentioned, there are many other fees associated with a commercial real estate loan, but the above-mentioned fees will be the ones seen the most often.
A prepayment penalty lays out the terms of requirements if the loan is paid off early. A bank wants to ensure they actually realize the value (or some of it) that they are projecting by giving the loan. If the new owner decides to sell in 9 months and pay off the entire mortgage, the bank wants assurance that they will still profit from the time and resources spent carrying the loan.
Prepayment penalty terms generally match the initial fixed-rate term. Sometimes they are expressed as a percentage of the outstanding loan balance; although there are other structures, such as a declining prepayment penalty (5% in year 1, 4% in year 2, etc.).
Banks will also include certain conditions that must be met throughout the life of the loan. These conditions (or covenants) are usually based upon the LTV and the Debt Service Coverage Ratio (DSCR).
The LTV covenant will state that the ratio cannot be more than a certain percentage, often the initial percentage requirement. So if the LTV for the initial loan had to be 65%, then the loan on the property can never be more than 65% of the property’s value. It is uncommon that this covenant would need to be enforced in today’s market, but it’s not historically impossible. During major economic crises, plummeting real estate values can push this LTV past the desired threshold.
The DSCR measures a property’s cash flow. This ratio equals the property’s Net Operating Incom (NOI) divided by the Debt Service Obligations (loan payments). Some banks use the EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) instead of the NOI for this figure, but in general, the end product is a similar DSCR.
As a standard, banks allow owner-occupied properties to have a lower minimum DSCR (min 1.20 – 1.25) than non-owner-occupied properties, which must have over 1.25 – 1.35 DSCR. The DSCR covenant will often require an annual review of financials on the property to verify that these numbers have not dipped below the minimum threshold.
If either of these covenants is found to be in default, the bank may require the owner to put more money down on the loan, bringing the numbers back to desired ranges. A discussion with the bank is always important, as abnormal circumstances can lead to a one-time occurrence (Covid-19 for instance), and the decreased DSCR or increased LTV may not be a consistent state.
Amortization can be confusing in commercial real estate loans, as the length of the period is most often different than the actual loan term. Remember that most commercial real estate loans with traditional bank financing are around 10 years. But the amortization periods are often longer (20-25 years). The amortization period, simply put, is the time it would take to pay the loan off in full. A longer amortization period means lower payments, while a shorter amortization period means higher payments.
While each commercial lending deal will look slightly different, this article highlighted the most common terms seen in commercial lending. In the following articles in this series, we’ll discuss what factors lenders look at for financing a commercial property, what the process looks like, and what types of loans are available to you.
Ready to learn more?
Read Part II: How to Get a Commercial Real Estate Loan
Read Part III: Types of Commercial Real Estate Loans
Disclaimer: The information contained in this article is not intended to provide legal or financial advice. Please speak to a commercial banker or financial adviser for professional guidance.