Commercial real estate lending: A comprehensive guide

Commercial real estate lending refers to financing or refinancing commercial properties. These properties are typically built on land designated for commercial use, such as warehouses, offices, or retail spaces. 

However, multifamily properties like apartment buildings, although sometimes located on residential or mixed-use zones, are also treated as commercial properties for financing purposes.

A key aspect of commercial real estate (CRE) lending is that the physical property serves as collateral to secure the loan.

## Types of commercial real estate loans

Commercial real estate loans come in various forms, each with unique structures and terms depending on the lender. Whether funded by a senior lender like a bank or a private equity firm, CRE loans fall into four main categories:

#### 1. Owner-occupied commercial mortgages

In this type of loan, the property is owned and occupied by the operating company. The company’s cash flow is used to service the loan, with credit underwriting based on business and financial health metrics (such as the 5 Cs of Credit). 

These loans typically amortize over 20-25 years and involve holistic debt service coverage (DSC) calculations that consider both company and property expenses.

#### 2. Income-producing commercial mortgages

This loan type is for investors who own properties leased to third-party tenants. The loan is serviced through rental payments, and the credit is based on factors such as tenant quality and lease terms. 

Amortization periods vary, generally between 15-25 years, depending on property risk. Warehouses and offices get longer terms, while specialized properties like golf courses get shorter ones.

#### 3. Construction loans

Construction loans finance the development or redevelopment of commercial properties. These loans are high-risk as they are disbursed before cash flow is generated. Payments are advanced in stages based on project milestones, and the entire principal, along with accrued interest, is repaid upon completion. Repayment typically comes from the sale of the property or through refinancing with a long-term mortgage.

#### 4. Bridge loans

Bridge loans are short-term solutions used when traditional financing is delayed. For example, after construction is completed, a bridge loan may be required to cover expenses until tenants are secured and the property can qualify for a long-term mortgage. Bridge loans come with higher interest rates and fees due to their elevated risk.

## Types of commercial real estate lenders

Commercial real estate lenders fall into two main categories: cash flow lenders and equity lenders.

#### 1. Cash flow lenders

Cash flow lenders, also known as “A” lenders, focus on the borrower’s ability to service the loan through net operating income or EBITDA. The property itself serves as collateral, but the borrower's ability to generate cash flow is paramount. 

These lenders offer lower interest rates because they can access cheaper capital. Examples include commercial banks, credit unions, and insurance companies.

#### 2. Equity lenders

Equity lenders, or “B” lenders, operate with higher risk tolerance and are willing to lend in situations where future cash flow is uncertain. They charge higher interest rates due to their higher cost of capital. 

These lenders focus heavily on the property’s value and are more likely to approve higher loan-to-value (LTV) ratios and second-charge mortgages. Equity lenders often specialize in riskier deals, such as bridge loans or properties outside prime urban areas.

## Commercial real estate terminologies

* **Loan-to-value (LTV):** The loan amount as a percentage of the property’s value, often determined by purchase price or appraised value.
* **Net operating income (NOI):** Gross rental income minus operating expenses, used to evaluate a property’s profitability.
* **Capitalization rate (Cap Rate):** A return metric, calculated by dividing NOI by property value, used for comparing properties.
* **Vacancy allowance:** A buffer built into financial projections to account for potential vacancies in rental properties.
* **Amortization period:** The time frame over which the loan principal is repaid, often ranging from 15-25 years.
* **Term:** The length of time the interest rate is fixed before the loan matures and must be renegotiated.

## Commercial real estate loans vs. residential loans

#### Commercial real estate loans

* Made to business entities like corporations or trusts.
* Loan terms range from five to 20 years, often with longer amortization periods.
* Loan-to-value (LTV) ratios typically range from 65% to 80%.

#### Residential loans

* Primarily made to individuals.
* Loans are usually amortized over 30 years.
* Higher LTV ratios (up to 100%) are possible with specific loan programs like USDA or VA loans.

## How to qualify for a commercial real estate loan

Qualifying for a commercial real estate loan is a more complex process compared to residential loans. 

Lenders evaluate several factors, including the borrower’s financial strength, the property's ability to generate income, and the overall risk of the deal. 

Key metrics like the debt service coverage ratio (DSCR) and loan-to-value (LTV) play a significant role in the approval process. A higher DSCR indicates a lower risk for lenders, while a lower LTV demonstrates that the borrower has invested more equity into the property. 

Additionally, lenders often require a detailed business plan outlining property usage, potential income, and market conditions.

## Common challenges in commercial real estate financing

Commercial real estate financing can present several challenges, particularly for first-time borrowers or developers. 

The most common hurdles include securing favorable loan terms, navigating fluctuating interest rates, and meeting the stringent qualification criteria set by lenders. 

Borrowers may also face difficulties in obtaining financing for niche or specialized properties, as lenders may view these as higher-risk investments. 

Additionally, fluctuating market conditions can impact property valuations, which in turn affects loan approvals and terms. Being prepared with a strong financial profile, a clear business plan, and contingency strategies is essential to overcome these challenges.

## FAQs

1. What is the main difference between cash flow and equity lenders?

Cash flow lenders prioritize the borrower’s ability to generate steady income, while equity lenders are more focused on the property’s value and are open to riskier deals.

2. How is a construction loan different from other commercial real estate loans?

Construction loans are used to finance development before the property generates cash flow. They are higher risk, with payments advanced in stages and repaid in full upon completion.

3. What are the typical terms for a commercial real estate loan?

Commercial loans generally range from five to 20 years, with amortization periods often longer than the loan term. Loan-to-value ratios typically fall between 65% and 80%.

4. What is a bridge loan in commercial real estate?

A bridge loan is a short-term financing solution used to “bridge” the gap between long-term financing options. It is often used when there is a delay in securing tenants or additional financing.

5. What factors affect the amortization period of a commercial real estate loan?

The amortization period depends on the property type and risk. More versatile properties like offices or warehouses may have longer amortization periods, while specialized properties like golf courses may have shorter terms.

Commercial real estate lending refers to financing or refinancing commercial properties. These properties are typically built on land designated for commercial use, such as warehouses, offices, or retail spaces.

Commercial real estate lending: A comprehensive guide

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