Commercial Real Estate Lending

What is Commercial Real Estate Lending?

Commercial real estate lending refers specifically to credit that is created to finance or refinance commercial property. 

With very few exceptions, commercial real estate (CRE) is property built on land designated with commercial zoning, like a light industrial warehouse, an office, or a retail property. The most notable exception is multifamily properties (like a rental apartment building); these may be built on residential or mixed-use zoning but are underwritten as commercial financing.

The common thread among all forms of CRE lending is that physical property serves as collateral to secure the credit exposure.

Commercial Real Estate – Context & Financing

The commercial real estate market in the United States is a major contributor to domestic GDP. According to IBISWorld Industry Research estimates, the commercial real estate market (measured by total revenue) represented USD $1.2tn[1]. 

Commercial real estate is the largest asset class after stocks and bonds (government and investment grade) and is valued at $8.8tn in 2021[2], ahead of cryptocurrencies, art, and others. 

What’s somewhat unique about CRE as an asset class is that debt tends to represent a large proportion of its funding. This requires that both real estate and financial services professionals have a strong understanding of how CRE lending is analyzed and underwritten.

The most common type of commercial real estate lending is a commercial mortgage. 

Types of Commercial Real Estate Loans

Real estate lending can take on many forms. The loan structure and terms may look quite different if funded by a senior lender (like a commercial bank or credit union) vs. a private equity lender or the public debt markets (for example, commercial mortgage backed security).

But in general, there are four categories of commercial real estate loans:

Owner–Occupied Commercial Mortgages

This is where the property serving as collateral is occupied by an operating company that has common ownership and/or control as that of the physical property (and the borrower). 

The mortgage is serviced using the operating company’s cash flow, so credit is underwritten based on its indicators of overall business and financial health (think 5 Cs of Credit). 

These loans are reducing and typically amortize over 20-25 years. The debt service coverage (DSC) ratio is usually calculated holistically (operating company and building expenses) to not inadvertently double count occupancy costs in financial metrics. For example, rent paid by the operating company is rental revenue for the building company, but not always set at arms’ length.

Income-Producing Commercial Mortgages

Borrowers are investors; they own property that is occupied by third-party, arms’ length tenants. 

Cash flow to service loan obligations comes from the tenants’ rental payments, so it’s key that lenders know how to make sense of lease terms and rent rolls. The credit is underwritten based on a variety of factors, including tenant quality and lease maturity profile, among others.

This type of commercial mortgage is reducing, and it will typically amortize over the course of 15-25 years, depending on the property class. A versatile property like a warehouse or a generic office will get a longer amortization, while a specialized property (like self storage or a golf course) are higher risk and tend to see shorter amortizations.

Construction Loans

Construction finance is a very specialized type of commercial real estate lending. Borrowing is extended to support the development and redevelopment of physical buildings, in advance of realizing potential cash flow. This makes it inherently higher risk than an amortizing commercial mortgage supported by predictable monthly payments.

Credit is advanced in stages (sometimes called “progress draws”) based on project milestones. These loans are interest only, generally with no cash interest payments throughout the term. The entire principal amount, including accrued interest, is repaid at one time upon project completion. 

Repayment typically comes from either the proceeds of property sale or it is “taken out” by one of the two commercial mortgages we covered earlier (depending on whether the property will be owner occupied or if it will be “leased up” with tenants).

Bridge Loans

These tend to be a higher risk type of CRE loan; they serve as a “bridge” between more traditional forms of credit. 

For example, a development project is completed, and the construction loan comes due. But maybe there’s a 6-month delay in getting the building tenanted so that the commercial mortgage lender won’t advance funds. This developer would need bridge financing to “take out” the construction loan while he or she waits for tenancy (and occupancy) so the commercial mortgage can advance.

These credit facilities are interest only and tend to come with higher rates and fees. This is higher risk lending; thus, most “A Lenders” (meaning cash flow lenders like commercial banks, credit unions, etc.) don’t do bridge financing. Private or otherwise non-bank equity lenders play in this space due to their higher risk tolerance for return on funds deployed.

Types of Commercial Real Estate Lenders

The best way to understand CRE lending is to put them into one of two big categories. The first is cash flow lending; the second is equity lending.

Cash Flow Lenders

Cash flow lenders, as the title suggests, care about cash flow. They employ what’s often called a bottom-up approach to underwriting; this means they start with net operating income (for investment properties) or net income/EBITDA (for owner-occupied properties).

The property will serve as collateral; however, the property’s value is somewhat secondary to the borrower’s ability to clearly service debt obligations (including interest rate buffers and other sensitization techniques).

Cash flow lenders are often called “A” or “prime” lenders, not because they’re better at lending, but because their sources of capital tend to be less expensive, so they get to pick through the best deals (i.e. strong cash flow and prime locations).

Most commercial banks, credit unions, and other large financial services firms (like insurance companies, pension funds, etc.) tend to play in the “A” space.

Equity Lenders

Equity lenders, often called “B” or “sub-prime” lenders, also like cash flow; however, they tend to do deals with less certainty around future cash generation. 

Many equity lenders are non-bank firms, so they have to pay a return to investors in exchange for the funds they lend out. Since their cost of funds is higher than a bank (which has deposits), they have to charge more in order to make a solid spread.

Equity lenders, as a result, tend to take on riskier deals (since they can charge a premium for it). “Risk” manifests as higher LTVs, second charges, properties outside of “prime” urban cores, more bridge loans, etc. 

Equity lenders are very reliant on the property’s highest and best use value in the event they need to take enforcement action against the borrower and the collateral.

Important Commercial Real Estate Terminology

The following terms are critical to know when seeking to understand commercial real estate lending.

• Loan-to-Value (LTV) – what the loan amount will be, expressed as a percentage of the total asset value. LTV may represent the loan amount relative to the purchase price, the appraised value, or some other calculated and verifiable indicator of “value.”
• Net Operating Income (NOI) – simply put, this is gross rental income, less operating expenses and adjustments. It’s a normalized profit metric that is used to quantify the economic value of an investment property.
• Capitalization Rate (Cap Rate) – can be thought of as a “return” metric. It’s calculated by dividing NOI by the market value of the property, expressed as a percentage. A property’s Cap Rate is used as a benchmark to compare it to other similar properties for the purpose of valuation.
• Vacancy Allowance – when looking at an investment property, it might be fully tenanted at the time of underwriting. But tenant turnover and downtime without rental income for vacant units is the cost of doing business. The vacancy allowance is a sensitization technique to simulate this cost by testing debt service capacity under the assumption that, in the long run, the vacancy rate is not zero for most properties.
• Amortization Period – is the number of months (or years) over which the principal repayments of a loan are spread. Put a different way, how many months before the mortgage loan is paid down to zero balance?
• Term – is the length of time that the interest rate is agreed to between the borrower and the lender. When the interest term is approaching maturity, new terms must be agreed upon, or the commercial mortgage is said to have “expired.”

Related Resources

CFI offers the Commercial Banking & Credit Analyst™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

• Real Estate Fundamentals 
• Real Estate Appraiser 
• LGD (Loss Given Default) 
• Loan Covenant
• See all commercial lending resources