Commercial Real Estate Lending

Credit provided to finance or refinance property owned for commercial purposes.

What’s Commercial Real Estate Lending?

Commercial real estate lending is Credit used to refinance or finance commercial property.

Commercial Real Estate (CRE) is a property designated with commercial zoning. Such as rental apartment houses are the exception. These properties can be built on residential or mixed-use zoning and underwritten with commercial financing.

All forms of CRE lending share a common thread: the physical property is used as collateral to secure credit exposure.

Key Highlights

• Commercial real estate lending refers to Credit secured by property in an area where commercial activity occurs.
• Commercial real estate has been an asset class that has used high amounts of debt to finance its growth.
• Commercial mortgages are the most popular type of retail realty credit, but bridge lending and construction financing are also available.
• Two broad types of commercial real estate lenders are possible: equity lenders and cash flow lenders.

Commercial Real Estate – Context & Financing

The US’s commercial real estate market significantly contributes to the country’s GDP. IBISWorld Industry Research estimates that the US retail real estate investing market, measured by total revenue, was USD 1.2tn [1].

After stocks and bonds (government, investment-grade), the most significant asset category is commercial real estate. It will be at $8.8tn by 2021 [2]. It is ahead of art and cryptocurrencies.

CRE is an asset class with a unique feature: CRE tends to have large amounts of debt funding. Real estate and financial service professionals must have a solid understanding of CRE lending analyzed and underwritten.

A commercial mortgage is the most popular type of commercial real estate lending.

Types Of Commercial Real Estate Loans

There are many types of real estate lending. The loan structure terms and conditions may differ if it is by a senior lender (such as a commercial bank, credit union, or private equity lender) or the public debt markets (such as commercial mortgage-backed security).

There are generally four types of commercial real property loans:

Owner-Occupied Mortgages

It happens when the collateral property of an operating business shares the same ownership and control of the physical property (and borrower).

Credit is therefore underwritten based on its indicators of financial health (think 5Cs of Credit).

These loans can last over 20-25 years, and, The debt service coverage ratio is often calculated holistically (operating and building expenses). Rental revenue for the building business is sometimes at arm’s length.

Income-Producing Commercial Mortgages

Borrowers are investors. They own property that third-party tenants occupy at arms’ length.

The tenants’ rent payments provide cash flow for loan service obligations. Therefore, lenders must understand lease terms and rent rolls. Credit is underwritten based on several factors, including tenant quality and lease maturity profile.

This commercial mortgage type is decreasing and will usually amortize over 15-25 years, depending on the property. While a versatile property such as a warehouse will see a longer amortization, specialized properties (such as self-storage or a course) have a higher risk and are subject to shorter amortizations.

Construction Loans

Construction finance: This is a highly specialized form of commercial realty lending. The purpose of borrowing is to finance the construction and redevelopment of physical buildings to generate cash flow. It is, therefore, riskier than an amortizing commercial mortgage with predictable monthly payments.

Sometimes called “progress draws,” based on project milestones. These loans pay interest only and generally do not have cash interest payments. After project completion, the entire principal amount plus accrued interest is in one lump sum.

Repayment usually comes from the proceeds from property sales or is “taken out by” one of the commercial mortgages we discussed earlier. It depends on whether the property is owner-occupied or “leased up” to tenants.

Bridge Loans

These loans are riskier than other CRE loans and serve as a “bridge” between traditional Credit.

The construction loan may be due. The commercial mortgage lender might not advance funds if there is a six-month delay in renting the building. The developer would need bridge financing to “take out” a construction loan while waiting for tenancy (and occupancy) so that the commercial mortgage can advance.

These credit facilities offer interest only and are subject to higher fees and rates. It is high-risk lending. Therefore, many “A Lenders” (meaning cash flow lenders like credit unions and commercial banks) disapprove of this lending. Don’t do bridge financing. Non-bank private equity lenders dominate this space. They are more willing to take on higher risks and return funds.

Types Of Commercial Real Estate Lenders

It is best to place CRE lending into one of the two major categories. First, there is cash flow lending. Second, there is equity lending.

Cash Flow Loans

As the title implies, cash flow lenders care about cash flow as a bottom-up approach to underwriting. They start with net operating revenue (for investment properties) and net income/EBITDA for owner-occupied properties.

Although the property will be as collateral, its value is partly secondary to the borrower’s ability to clear service obligations (including interest rate buffers and other sensitization methods).

They are sometimes called “A” or ‘prime lenders. It is not because they do a better job of lending but because their capital sources tend to be cheaper, so they can pick the best deals (i.e., Strong cash flow and prime locations are two reasons that cash flow lenders are so popular.

Commercial banks, credit unions, and significant financial service firms, such as insurance companies, pension funds, etc., are dominated by commercial banks. The “A” space is where most financial services are.

Equity Lenders

These equity lenders are often called “B” (or “sub-prime”) lenders. They also like cash flow but tend to make deals with less certainty about future cash generation.

Non-bank equity lenders often have to pay investors a return on their money. Because their costs of funds are higher than those of banks (which have deposits), they must charge more to make a solid spread.

As a result, equity lenders are more likely to accept riskier deals since they can charge a premium. Risk manifests in higher LTVs, second fees, properties not located in “prime” urban centers, and more bridge loans.

In the event of enforcement actions against the borrower or collateral, equity lenders heavily depend on the property’s best and highest use value.

Important Commercial Real Estate Terminology

These terms are crucial to understanding when trying to understand commercial real estate lending.

• LTV – This is the amount of the loan, expressed in percentage of total asset value. LTV could indicate the loan amount relative to the purchase price, appraised, or any other verifiable indicator that “value” is.
• Net Operating Income (NOI ) – This is the gross rental income less operating expenses and adjustments. It is a normalized profit metric used to determine a property’s economic value.
• Cap Rate (Cap Rate) – This can be considered a “return” indicator. You are subtracting NOI from the market value of the property. This percentage. The Cap rate of a property to compare it with other similar properties for valuation purposes.
• Vacancy Allowance- An investment property might have when it. Tenant turnover and downtime with no rental income are part of the cost of doing business. It tests debt service capacity and simulates this price.
• The amortization period is the period over which principal repayments are. What is the period before your mortgage loan balance is zero?

The term is when the borrower and lender agree to an interest rate if the interest term approaches maturity.