A commercial real estate loan is not the same as a home loan.

Commercial real estate (CRE) is an income-producing property that is only used for business reasons (rather than residential). Retail malls, shopping centers, office buildings and complexes, and hotels are all examples. Commercial real estate loans are used to finance the acquisition, development, and construction of these properties. These loans are secured by liens on the commercial property.

What is the definition of a commercial real estate loan?

Commercial real estate loans are made by banks and independent lenders in the same way that home mortgages are. Commercial real estate is also financed by insurance companies, pension funds, private investors, and other sources, including the US Small Business Administration's 504 Loan program.

We'll look at commercial real estate loans, how they differ from residential loans, what lenders look for, and how to get one.

The Differences Between Residential and Commercial Real Estate Loans

Loans for Commercial Property
  • Business firms are typically the recipients of commercial real estate loans (corporations, developers, limited partnerships, funds and trusts).
  • Commercial loans typically last between five and twenty years, with the amortization time often exceeding the loan length.
  • The loan-to-value ratio for commercial loans is typically between 65 and 80 percent.
residential Loans
  • 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 fixed-rate mortgage is the most popular residential mortgage product.
  • Certain residential mortgages, such as USDA or VA loans, allow for high loan-to-value ratios of up to 100%.

Check out this Northern Michigan Commerical Real Estate video

Individuals vs. Organizations

While most residential mortgages are given to individuals, commercial real estate loans are frequently given to corporations (e.g., corporations, developers, limited partnerships, funds and trusts). These companies are frequently founded with the express goal of holding commercial property.

The lender may ask the principals or owners of the entity to guarantee the loan if the entity has no financial track record or credit rating. This offers the lender with a credit-worthy individual (or group of individuals) from whom they can recover funds in the case of a loan default. If the lender does not require this form of assurance and the property is the only method of recovery in the event of loan default, the debt is referred to as a non-recourse loan, which implies the lender has no recourse against anyone or anything other than the property in the event of default.

Repayment Schedules for Loans

A home mortgage is a sort of amortized loan in which the debt is paid off over time in regular installments. The 30-year fixed-rate mortgage is the most popular residential mortgage product, although there are also 25-year and 15-year mortgage options available. Longer amortization periods are associated with lower monthly payments and higher total interest costs over the loan's life, whereas shorter amortization periods are associated with higher monthly payments and lower total interest costs.

Residential loans are amortized during the duration of the loan, ensuring that the loan is paid off in full at the end of the period.

For example, a buyer of a $200,000 home with a 30-year fixed-rate mortgage at 3% would make 360 monthly payments of $1,027 before the loan was paid off. These values are based on a 20% down payment. 2

Unlike residential loans, commercial loans often have periods ranging from five years (or less) to twenty years, with an amortization period that is often greater than the loan term. For example, a lender might make a commercial loan with a seven-year term and a 30-year amortization period. In this case, the investor would make seven years of payments based on the loan being paid off over 30 years, followed by a final "balloon" payment of the full remaining loan total.

For example, a $1 million commercial loan with a 7% interest rate would require monthly payments of $6,653.02 for seven years, followed by a final balloon payment of $918,127.64 to pay off the loan completely.

The interest rate charged by the lender is influenced by the loan term and amortization period. These parameters may be negotiated depending on the creditworthiness of the investor. In general, the greater the interest rate, the longer the loan repayment period.

Ratios of Loan-to-Value

Another distinction between commercial and residential loans is the loan-to-value ratio (LTV), which compares the loan's value to the property's worth. LTV is calculated by dividing the loan amount by the property's appraised value or purchase price, whichever is lower. The LTV for a $90,000 loan on a $100,000 property, for example, would be 90% ($90,000 $100,000 = 0.9, or 90%).

Borrowers with lower LTVs will qualify for better financing rates on both commercial and residential loans than those with higher LTVs. The reason for this is that they have greater equity (or ownership) in the property, which means the lender sees them as a lower risk.

For some types of residential mortgages, high LTVs are permitted: VA and USDA loans have a maximum LTV of 100%; FHA loans (loans insured by the Federal Housing Administration) have a maximum LTV of 96.5 percent; and conventional loans have a maximum LTV of 95 percent (those guaranteed by Fannie Mae or Freddie Mac). 

Commercial loan LTVs, on the other hand, often vary from 65 to 80 percent.

Although larger LTV loans are possible, they are uncommon. The LTV varies depending on the loan category. For example, bare land may be granted a maximum LTV of 65 percent, whereas multifamily construction may be allowed an LTV of up to 80 percent.

In commercial financing, there are no VA or FHA programs, and no private mortgage insurance. As a result, lenders are reliant on the real estate pledged as security because they have no insurance to cover borrower default.

The ratio of Debt-Service Coverage

The debt-service coverage ratio (DSCR) compares a property's annual net operating income (NOI) to its annual mortgage debt service (including principal and interest) to determine the property's capacity to service its debt. It's computed by dividing the annual debt service by the NOI.

A property with $140,000 in yearly NOI and $100,000 in annual mortgage debt payment, for example, has a DSCR of 1.4 ($140,000 $100,000 = 1.4). The ratio aids lenders in determining the maximum loan size depending on the property's cash flow.

A negative cash flow is indicated by a DSCR of less than one. A DSCR of.92, for example, suggests that the NOI is only enough to cover 92 percent of annual debt service. To ensure appropriate 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. 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, higher ratios may be required.

Interest Rates and Fees on Commercial Real Estate Loans

Commercial loan interest rates are often higher than residential loan interest rates. In addition, commercial real estate loans typically include expenses such as appraisal, legal, loan application, loan origination, and/or survey fees, which contribute to the overall cost of the loan.

Some fees must be paid upfront before the loan may be authorized (or denied), while others must be paid on a yearly basis. A loan may, for example, contain a one-time loan origination cost of 1% due at closing and an annual fee of one-quarter of one percent (0.25%) until the loan is fully paid. For a $1 million loan, for example, a 1% loan origination cost of $10,000 would be required upfront, with a 0.25 percent yearly fee of $2,500. (in addition to interest).


Prepayment restrictions may be imposed on a commercial real estate loan in order to protect the lender's expected yield. If the investors pay off the debt before the loan matures, they will almost certainly face prepayment penalties. For paying off a debt early, there are four sorts of "exit" penalties:

  • Penalty for paying in advance. This is the most basic prepayment penalty, which is determined by multiplying the current outstanding balance by a prepayment penalty of your choosing.
  • Guaranteed interest rate. Even if the loan is paid off early, the lender is entitled to a certain amount of interest. For example, a loan could have a guaranteed interest rate of 10% for 60 months, followed by a 5% exit charge.
  • Lockout. The borrower is unable to repay the loan before a set time limit, such as a five-year lockout period.
  • Defeasance. A collateral substitute. Instead of paying cash to the lender, the borrower replaces the old loan collateral with fresh collateral (typically US Treasury securities). This can help you save money on fees, but it can also come with hefty penalties.
    In commercial real estate loans, prepayment terms are specified in the loan agreements and can be negotiated together with other loan terms.

Final Thoughts

When it comes to commercial real estate, an investor (usually a business organization) buys the building, leases out space, and collects rent from the tenants. The property is meant to be an income-producing investment.

Lenders consider the loan's collateral, the entity's (or principals '/owners') creditworthiness, which includes three to five years of financial statements and income tax returns, and financial ratios such as the loan-to-value ratio and the debt-service coverage ratio, when evaluating commercial real estate loans.

"I have significant experience buying and selling Northern Michigan commercial real estate and I'd like to help you find the perfect investment. Send me a message or give me a call at (231) 459-4257 to learn more today."

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