Commercial real estate is a lucrative asset type for investors seeking to generate rental income and capital gains from their physical property investments. In most cases, purchasing a commercial property requires applying for a specific type of loan – a CRE loan – as the value of these assets is quite high.
In this article, we will be digging deeper into the basic concepts an investor would need to know to get into commercial real estate investing along with key definitions regarding commercial real estate loans including what they are, how many types of loans exist, and what kind of requirements financial institutions will typically ask for.
What is commercial real estate?
Commercial real estate (CRE) encompasses any property used solely for business purposes rather than residential living. Unlike homes purchased by individuals, CRE properties like office buildings, warehouses, retail stores, and apartment buildings are acquired by investors seeking to generate ongoing rental income. Commercial real estate offers unique advantages that make it an attractive asset class for many investors.
First and foremost, commercial properties bring in significantly higher rents per square foot compared to residential real estate. Well-managed commercial assets routinely deliver returns between 8-12% or more. The reason behind the higher rents is that businesses require specialized spaces to operate and conduct commercial activities. They are willing to pay premium rates for functional properties in desirable locations.
Another major benefit of commercial real estate is the longer initial lease terms tenants commit to, typically 3-10 years or longer versus just 1 year for residential rentals. Lengthy leases provide rental income stability and predictability over time. Commercial tenants also handle most interior maintenance themselves as part of triple net leases, reducing landlord responsibilities and costs.
Investors further benefit from tax deductions on depreciation and other write-offs that are not available with residential properties. Commercial real estate also benefits from economies of scale with larger properties efficiently serving multiple tenants and increasing overall income potential. Lastly, rents and property values tend to keep pace with inflation over the long run, which makes them a hedging strategy to protect the purchasing power of investors’ hard-earned wealth.
What are commercial real estate loans and how do they work?
Commercial real estate investors often turn to loans rather than paying for the purchase in cash for several reasons. First, coming up with the full purchase price in cash may not be feasible, especially for large and expensive properties. Loans allow investors to leverage their existing capital and acquire more assets. Second, keeping cash free for other investments and opportunities provides more financial flexibility. And third, the interest expense on a loan is tax deductible, providing another benefit.
Commercial real estate loans are offered by various lending institutions including banks, credit unions, insurance companies, pension funds, private lenders, and government agencies.
To obtain a loan, many investors enlist the services of a commercial mortgage brokerage firm. These firms act as intermediaries between borrowers and lenders. They assist borrowers in finding suitable financing options for their particular situation and property type.
Commercial mortgage brokerages have well-established relationships with lenders and can help investors identify the best loan rates and terms. They also handle the application process and loan underwriting.
Key elements of a commercial real estate loan
- Loan Amount: The total dollar amount being borrowed from the lender. It is determined based on factors such as the property's appraised value, projected net operating income, and the borrower's overall financial standing.
- Loan-to-Value Ratio (LTV): The percentage of the total cost of the property that will be covered by the loan amount. Typically ranges from 50% to 80% for commercial real estate loans. The remaining percentage is covered by the borrower's down payment.
- Interest Rate: A periodic charge on the loan, expressed as a percentage. Can be fixed for the full loan term or variable/adjustable. Interest rate influences the borrower's financing costs.
- Repayment Period: The number of years that it will take the borrower to repay the principal loan balance. Typically, this period ranges from 5 to 10 years for commercial real estate loans.
- Amortization Schedule: The full schedule detailing how the principal loan balance and interest will be paid down over the entire loan term through periodic installments.
- Debt Service Coverage Ratio: The minimum ratio between the property's net operating income and its debt service that must be maintained. It measures the ability of the landlord to pay his debt obligations.
- Prepayment Penalties: The fees charged by the lender if the borrower pays off the loan before the established repayment period. Its goal is to deter early repayment.
- Recourse vs. Non-recourse: Recourse loans hold the borrower personally liable if the property income is insufficient to cover debt service. Non-recourse limits liability to the seizure of the property only.
- Assumability: Allows a new property buyer to take over or assume the seller's existing loan instead of getting a new mortgage. Depends on lender approval.
- Reserves: The minimum dollar amount a borrower must keep on hand to continue covering debt service payments if the property's net operating income declines.
Bottom line
Commercial real estate loans provide access to capital that may otherwise be unavailable, allowing investors to expand their portfolios. With the right loan structure, both the borrower and lender can benefit.
In addition, obtaining commercial real estate loans allows investors to acquire income-producing assets while preserving capital resources. By leveraging a lender's money secured by the property as collateral, investors gain financial flexibility.
Aidan has been writing about personal finance for over 6 years. Prior to this, he worked as a Corporate Finance Analyst where he specialized in Due Diligence, Company Valuations and more. He is a CFA charterholder.
