Jan 3, 2022
A property that provides income solely for commercial (rather than residential) reasons is known as commercial real estate (CRE). Examples include shopping malls, shopping centers, office buildings and complexes, and hotels. Commercial real estate loans, which are backed by liens on the property, are frequently used to fund the purchase, development, and construction of commercial properties.
Like residential mortgage lenders, banks and independent lenders are actively involved in making commercial real estate loans. Small Business Administration's 504 Loan program is available to insurance companies, pension funds, private investors, and other commercial real estate financing sources.
We'll look at small commercial real estate loans, how they differ from residential loans, their qualities, and what lenders look for in them.
· Commercial real estate loans are typically issued to corporations (corporations, developers, limited partnerships, funds, and trusts).
· Commercial loans often have terms ranging from five to twenty years, with the amortization time often greater than the loan term.
· Loan-to-value ratios for commercial loans typically vary between 65 and 80 percent.
· Individual borrowers are often the recipients of residential mortgages.
· Residential mortgages are a type of amortized loan in which the debt is repaid over time in regular installments. The 30-year traditional mortgage is the most popular residential mortgage product.
· Certain types of residential mortgages, such as USDA or VA loans, allow for loan-to-value ratios as high as 100%.
While residential mortgages are primarily offered to individuals, commercial real estate loans are sometimes made to organizations (e.g., corporations, developers, limited partnerships, funds, and trusts). These corporations are frequently formed with the express aim of holding commercial real estate.
If an entity lacks a financial track record or a credit rating, the lender may demand the entity's principals or owners to guarantee the loan. This offers the lender with a credit-worthy individual (or group of individuals) from whom they can collect in the case of loan default. The debt is referred to as a non-recourse loan if the lender does not require this sort of guarantee and the property is the only means of recovery in the event of loan default. This indicates that the lender has no recourse against anyone or anything other than the property.
A home mortgage is a sort of amortized loan in which the debt is repaid over time in regular installments. The 30-year traditional mortgage is the most popular residential mortgage product, but other options are available to home buyers, including 25-year and 15-year mortgages. Longer amortization terms are associated with lower monthly payments and higher total interest costs during the life of the loan, whereas shorter amortization periods are associated with higher monthly payments and lower total interest expenses.
Residential loans are amortized during the life of the loan, allowing the loan to be entirely repaid at the conclusion of the loan term. For example, a buyer of a $200,000 home with a 30-year fixed-rate mortgage at 3% would pay $1,027 a month for 360 months before the loan was paid off. The following figures are based on a 20% down payment.
Unlike residential loans, small commercial loan lengths often range from five years (or less) to twenty years, with the amortization time often greater than the loan term. A lender, for example, might make a business loan for seven years with a 30-year amortization period. Based on a30-year loan term, the investor would make payments for seven years, followed by a final "balloon" payment of the entire loan amount.
A $1 million commercial loan with a 7% interest rate would require monthly payments of $6,653.02 for seven years, with a final balloon payment of $918,127 to completely settle the amount.
The interest rate charged by the money lender is affected by the loan duration and amortization period. These terms may be negotiated depending on the investor's creditworthiness. In general, the greater the interest rate, the longer the loan repayment periods.
Another distinction between small commercial and residential loans is the loan-to-value ratio (LTV), a number that compares the value of a loan to the value of the property. LTV is calculated by dividing the loan amount by the lesser of the appraised value or the property's purchase price.For example, the LTV for a $90,000 loan on a $100,000 property is 90% ($90,000$100,000 = 0.9, or 90%).
Borrowers with lower LTVs will qualify for cheaper interest rates on commercial and residential loans than those with higher LTVs. The reason is that they have more equity (or a stake) in the property, which means less risk from the lender's perspective.
There are no VA or FHA programs in commercial financing, nor is there private mortgage insurance. As a result, lenders have no insurance to cover borrowers' default and rely on the pledged real estate as security.
The debt-service coverage ratio (DSCR) is a calculation that compares a property's annual net operating income (NOI) to its yearly mortgage debt service (principal and interest), demonstrating the property's ability to repay its debt. It's calculated by dividing the annual debt service by the net operating income.
A property with $140,000 in NOI and $100,000 in annual mortgage debt service, for example, would have a DSCR of 1.4 ($140,000 $100,000= 1.4). Based on the cash flow provided by the property, the ratio assists lenders in determining the maximum loan size.
A negative cash flow is shown by a DSCR less than one. ADSCR of.92, for example, indicates that there is just enough NOI to satisfy 92 percent of annual debt service. To ensure proper cash flow, commercial lenders aim for DSCRs of at least 1.25.
For loans with shorter amortization terms and/or assets with consistent cash flows, a lower DSCR may be appropriate. Higher ratios may be needed for assets with fluctuating cash flows, such as hotels, which lack the long-term (and thus more predictable) tenant contracts found in other types of commercial real estate.