Commercial Real Estate Loan Calculator
What You Should Know
- Commercial real estate loans are for large-scale investors or businesses.
- The interest rates are higher than residential loans; ranging from 8% to 18%.
- The application is similar to residential mortgages, however your DSCR is assessed.
- The structure is designed to maximize ROI by using interest-only payments.
Commercial Mortgage Overview
A commercial mortgage provides the ability to purchase commercial real estate. In most cases, the loan is used by real estate investors to purchase, expand or renovate properties to generate income. However, investors can also use it to develop land and commercial construction projects.
Aside from investors, commercial mortgages can be used by any company looking to buy property. For example, a small business may use a commercial mortgage to buy a warehouse or office building.
Regardless of the borrower, the loan characteristics and application process will be similar. Lenders will review the borrower's credit report, income ratios, and existing assets.
The repayment structure sets a commercial mortgage apart from a conventional loan. Commercial loans typically have interest-only payments month to month. The interest payments last for the loan term length, which is usually ten years. Borrowers prefer smaller payments because it improves their net operating income (NOI).
After the term ends, there is a big lump-sum payment due. This is known as a balloon payment. However, most borrowers refinance the loan instead of paying the balloon into another mortgage.
Key Concepts of Commercial Real Estate Loans
Most commercial mortgages have monthly interest-only payments. This means that the borrower only pays the interest on the loan each month, not the principal. This results in decreased monthly payments.
Borrowers prefer this to maximize monthly net operating income. However, it also means that the principal balance remains unchanged until the end of the loan term. When the term ends, borrowers are required to make a balloon payment.
A balloon payment is a lump-sum payment due at the end of the term. Typically it’s the remaining mortgage balance. However, many borrowers choose to refinance their loan into another commercial mortgage instead of making this big payment. You can use a balloon mortgage calculator to determine the payment size.
The new mortgage covers the balloon payment and replaces the old mortgage. The process starts over again with interest-only payments and another balloon payment due at the end of the new term.
Ideally, the commercial property increases in value over time. This increases equity and decreases the LTV ratio. With equity, the borrower can cash out refinance at the end of their term. Some borrowers use this cash as a down payment for another income-generating property.
Additionally, the borrower may refinance into lower market interest rates. This will reduce payments and increase the NOI. Borrowers may also increase NOI by extending the loan amortization.
However, when refinancing, the borrower must requalify for a mortgage. As a result, it’s essential they meet DSCR, LTV, and creditworthiness requirements. These are mentioned in more detail below.
Net Operating Income (NOI)
Net operating income (NOI) is the yearly profit of a property after deducting all expenses. This includes; mortgage payment, insurance, property taxes, maintenance and repair costs, and on-site management fees.
NOI is important to lenders because it shows how much money you have left to pay your mortgage payments. The higher the NOI, the better for lenders because it offers a surplus of profits to cover debt payments. To calculate it, you subtract all expenses from your gross income. The equation is:
In addition to calculating NOI, lenders will also review how stable your NOI is throughout the years. They want to see steady or increasing NOI instead of fluctuating or declining profits. This shows stability and reliability in your income stream for loan payments.
Debt Service Coverage Ratio (DSCR)
When evaluating your loan application, lenders calculate your debt service coverage ratio (DSCR). The ratio shows the number of times your NOI can cover your monthly debt payments. It's the inverse of a debt-to-income ratio used for residential mortgages.
A higher ratio is better because it shows you have a surplus of profits and a buffer zone to service debt payments confidently. To calculate DSCR, you divide NOI by your debt service. It's essential to ensure they have the same units, such as monthly or annually. The equation is:
Most lenders require a minimum DSCR of 1.25. However, the ratio can be lower with a shorter amortization period or when the business has stable cash flows throughout the year.
On the contrary, businesses with fluctuating cash flows may require a higher DSCR approval. This is because the company may be unable to cover the loan payments during periods of low activity.
Loan to Value (LTV) Ratio
Another essential ratio used by lenders is the loan-to-value (LTV) ratio. This ratio shows how much of the property's value is financed by a loan. A more significant down payment decreases your LTV ratio.
When you first buy a property, the LTV is the opposite of your down payment. However, your LTV decreases over time as the property value increases and you pay off your mortgage principal.
Lenders prefer a lower LTV ratio because they have less default risk. This is because they have more safety cushion to sell the property and get their money back. As a result, a lower LTV decreases risk for lenders if you default on your loan. The equation is:
Most commercial real estate lenders look for an LTV ratio between 65% to 80%. However, the specific LTV ratio requirement will depend on a few factors, such as;
- The type of loan you are applying for
- The type of property involved
- Your DSCR
- Your business and personal creditworthiness
The final important concept is creditworthiness. Commercial mortgage lenders will primarily assess the business's creditworthiness. Most lenders want to see a company with at least two years of history. If the business doesn't have sufficient financial records or credit history, the lender will personally assess the borrower. In this case, the owner's assets will be held accountable if the business defaults on the loan.
In general, lenders determine creditworthiness through the following methods:
- Financial analysis: Reviewing tax returns, financial books, reports, bank statements, etc.
- Business Credit Score: If the business has had some credit activity in the past, lenders will typically look at the FICO SBSS (Small Business Scoring Service) score. Some commercial loans have minimum FICO SBSS credit score requirements.
- Personal Credit Score: The lender will calculate your net worth and check bankruptcy history or if there are any financial liens on your property. Additionally, the owner's financial standing may improve or decrease the business's chances of getting a commercial real estate loan.
Commercial vs. Residential Mortgages
|LTV||65% - 80%||Up to 100%|
|Repayment Schedule||5 - 20 years||15 - 30 years|
|Private Mortgage Insurance||Not required||With down payments below 20%|
|Guaranteed by||Business entity, owners||Owners|
The Six Types of Commercial Real Estate Loans
1. Permanent Loan
These are the most common commercial mortgage and are similar to residential loans. Personal loans are offered widely by most commercial lenders.
However, these lenders are typically risk-averse and prefer fully developed properties with a low vacancy rate. As a result, permanent loans are best used with "blue chip" real estate.
2. SBA Loan
SBA real estate loans are commercial loans that the U.S. Small Business Administration guarantees. This reduces the risk for lenders and provides incentives for lenders to offer small business loans.
When getting an SBA loan, you may be required to pay a guarantee fee of 3.75% of the loan that the SBA guarantees. There are two types of SBA loan programs that businesses can use depending on their needs.
a) SBA 7(a) Loan: SBA's most popular loan program. SBA 7(a) commercial loans can be used for various needs, from financing the purchase of real estate to purchasing inventory or working capital.
b) SBA 504 Loan: This loan program is intended for businesses that want to purchase, construct or renovate significant fixed assets. There are additional minor business criteria to qualify. For example, the company must prove it has a net worth below $5 million.
|SBA 7(a)||SBA 504|
|Interest Rate||Fixed or variable-rate||Fixed-rate|
|Maximum Loan Size:||$5 million||$5 million|
|Minimum Down Payment||10%||10%|
|Financed by:||Preferred private lenders, such as Wells Fargo Bank, U.S. Bank, and JPMorgan Chase.||Hybrid of Certified Development Companies (CDC) and private lenders.|
3. Bridge Loan
Bridge loans are commercial real estate loans generally used for short-term purposes. They are called 'bridge' loans as they are used to bridge the gap when the business owner is looking for long-term financing.
A bridge loan can cover the lack of funds until then. Businesses that plan to refinance their existing loan can also use bridge loans.
The term of a bridge loan usually ranges from 6 months to 3 years. These shorter terms present a higher risk to lenders, so they will charge a higher interest rate for bridge loans and put stricter financial requirements to qualify.
The down payment required for a bridge loan is typically between 10% and 20% of the loan amount.
4. Hard Money Loan
Hard money loans are similar to bridge loans. The main difference is that hard money loans are not offered by banks but by individuals or companies.
For private lenders of hard money loans, the property's value is more critical than the borrower's creditworthiness. Therefore, it is easier to qualify for this type of loan.
These lenders are okay with the risk of not thoroughly checking the borrowers' creditworthiness because they might profit more by selling the property if the borrower defaults.
Hard money loans usually have a term of 6 months to 3 years and come at higher interest rates than other commercial real estate loans. In 2020, the interest rate averaged 11.25%.
Moreover, the LTV ratio required is usually 50% - 70% of the loan amount, which is relatively lower than what other commercial real estate loans allow.
5. Soft Money Loan
Soft money loans share some characteristics of hard money loans and traditional mortgages. Like hard money loans, they are offered by private lenders, typically short-term, and close faster.
However, soft money lenders are more concerned with the property value than the borrower's creditworthiness. A higher credit score would probably get you more favorable terms with a soft money loan than a hard money loan. Also, interest rates for soft-money loans tend to be lower.
6. Conduit/CMBS Loan
A conduit or CMBS loan is a form of a securitized commercial mortgage. This means that similar commercial mortgages are pooled together and sold to investors in the secondary market.
These loans are used only for income-generating properties and cannot be used for land or property construction. Conduit loans offer several benefits to borrowers that would typically not qualify for other commercial real estate loans.
First, conduit loans are usually non-recourse loans. Non-recourse loans are loans that do not have to be guaranteed by the business owners. As mentioned earlier, the lenders may look into the owner's finances when the business needs more financial track records.
Secondly, conduit loans have fixed interest rates, typically lower than traditional mortgages. They come in amortization periods of 15-, 20- and 30 years and can fund up to $50 Million worth of investment.
One drawback is that CMBS loans usually have prepayment penalties, which means that if you want to pay off the balance beforehand, you will be charged a fee.
Interest Rates and Fees
Commercial real estate loans generally have higher interest rates than residential loans. The interest rates can range from 2% for SBA loans to 18% for hard money loans. The costs associated with taking out a commercial loan are also usually higher. These costs can include the following:
- Loan origination fees → Usually 0.5% - 1% of the loan amount
- Loan application fees → Can range between $500 to as high as $200,000
- Appraisal fees → $2,000 - $3,000 depending on property size and state
- Building inspection report → $500 - $5,000 depending on property size and state
- Legal costs
The business might be required to pay some fees directly upfront, some annually, or a combination of a smaller upfront fee and annual payments.
Loan Repayment Schedule
Commercial real estate loans typically have terms of 5 years or less to 20 years. The amortization period of these loans is usually longer. At the end of a commercial loan term, the business has to refinance or make a balloon payment to cover the remaining balance.
On the other hand, residential properties have terms of 15 to 30 years, with the most popular product being the 30-year fixed-rate mortgage. Like residential loans, longer-term commercial real estate loans typically have higher interest rates.
Private Mortgage Insurance
While residential lenders shift some risks to insurance companies by charging private mortgage insurance premiums to borrowers who put in less than a 20% down payment, commercial real estate lenders tend to keep the risk on their own. This means there is no private mortgage insurance for commercial real estate loans.
Lenders expect to make a specific yield on their investment. This yield is calculated based on the interest payments that the borrower will have to make. If the borrower prepays the loan early, the lender's yield decreases.
For the lender to guarantee profits, they charge prepayment penalties. These are the fees that the borrower has to pay if they want to retire the loan. There are four main types of prepayment penalties: