Commercial Real Estate Financing Fundamentals
Commercial real estate (CRE) loans differ fundamentally from residential mortgages in terms, requirements, and risk assessment. While residential loans focus on borrower creditworthiness, CRE loans emphasize property cash flow and debt service coverage ratio (DSCR)—the ratio of property net operating income to debt service. Lenders typically require DSCR of 1.25-1.50x, meaning the property must generate 25-50% more cash flow than required loan payments. CRE loan terms typically include higher down payments (25-35%), shorter amortization periods (15-25 years), balloon payments, and higher interest rates (1-2% above residential rates).
CRE loan structures vary by property type and intended use. Traditional commercial mortgages offer the best terms (5-7% interest, 25-year amortization) but require established property cash flow and significant down payments. SBA 504 and 7(a) loans provide favorable terms for owner-occupied commercial real estate (down to 10% down payment, longer terms) but involve complex processes and restrictions. Bridge loans offer short-term financing (1-3 years) at higher rates (8-12%) for properties needing repositioning or renovation before qualifying for permanent financing. Each structure serves different situations and investment strategies.
The debt service coverage ratio calculation drives CRE lending decisions. DSCR equals annual net operating income (NOI) divided by annual debt service. A property generating $120,000 in NOI with $90,000 in annual loan payments has a 1.33 DSCR—generally acceptable for conventional financing. If that same property had $100,000 in debt service (1.20 DSCR), many lenders would decline or require a larger down payment to reduce loan amount and improve DSCR. NOI equals rental income minus operating expenses (insurance, taxes, maintenance, property management) but excludes debt service, depreciation, and capital improvements.
Commercial real estate financing requires understanding amortization schedules versus loan terms. Many CRE loans feature 20-25 year amortization but 5-10 year terms, resulting in balloon payments where the remaining balance must be refinanced or paid off. This structure protects lenders from long-term interest rate risk but exposes borrowers to refinancing risk—if property values decline or your financial situation changes, you might be unable to refinance at term end. The amortization period affects payment size and equity building; shorter amortization means higher payments but faster equity growth and less interest paid over time.