5 Key Commercial Real Estate Terms Every Investor Should Know

In this blog, what we’re going to do is go over five key commercial real estate loan terms that you need to know before heading into your first or next commercial real estate investment deal.

So if you’re looking to buy your first commercial real estate investment property, or you’re looking to break into commercial real estate and want to understand how commercial real estate loans work definitely stick around for this blog.

So by the end of this blog you’re going to know five different commercial real estate loan terms that you need to know specific to commercial deals as a borrower and how each of these is going to affect the cash flows on your deal.

So the first term that’s generally going to differ from a single-family home loan. Is that commercial real estate loans often have what are called interest-only periods and an interest-only period is exactly what it sounds like.

It’s a Area of time where you only pay interest payments on your outstanding balance of the loan now oftentimes, this is offered by lenders for the first 12 to 36 months of alone, especially when there’s a major renovation going on at the property and cash flow might be a little bit tight in the first one to three years of that deal.

Now as a borrower this can make a huge difference in your overall cash flow, especially if you’re adding value to the property so take for example, a 1.5 million dollar property.

And let’s say on that one point five million dollar property acquisition.

You put a 1 million dollar loan on that deal for a 66 percent loan to value. Now. Let’s also say that that loan is a 25-year amortizing loan and it’s a five percent interest rate.

And with that your annual loan payment would be seventy thousand one hundred and fifty one dollars. However, if that first year was just interest-only payments your overall Debt Service to that lender for the first year would drop over $20,000.

On to $50,000 for the entire year. Now. This is really helpful because it can drastically increase your cash on cash return during this time period so let’s say for that same scenario that property that you buy is a six percent cap rate meaning that in that first year you can expect to earn 90,000 dollars in net operating income after all expenses are paid.

Now that said in the scenario where you pay those principal payments your cash on cash return is only three point nine.

In seven percent but in the scenario where you only pay interest payments your cash on cash

return jumps from three point nine seven percent to 8 percent for the year now, especially if you’re planning to add value to the property and grow that net operating income over time getting that boost in your cash on cash return and making sure that you’re achieving that

for your investors can be huge for your overall Returns on the deal.

Now the second term that you’ll run into in a commercial real estate deal is a prepayment.

Now if you go to sell your single family home and you pay off that loan.

Generally you’re not going to have any sort of penalty associated with that. But in the case of commercial real estate often times, you’ll have some sort of a prepayment fee associated with paying the loan off before that loan actually matures.

Now, this can be based off of a few different things.

But generally as a prepayment penalty, you’re going to see a prepayment penalty as either a percentage of the loan amount or a yield maintenance prepayment penalty now for a flat percentage Ownage prepayment penalty.

Usually you’ll see this as what’s called a step-down amount. So you may hear someone referring to a seven-year loan term with a 5 4 3 2 1 prepayment penalty and what that means is that that prepayment penalty is 5% in that first year four percent in that second year 3% in that third year and so on.

So in this scenario, obviously the later your prepayment the lower your prepayment penalty is going to be and if you’re in those last two years of the loan. And you likely won’t have any sort of prepayment penalty on that loan.

Now yield maintenance is much more complicated than the flat rate percentage. But essentially with the yield maintenance prepayment penalty is doing is it’s making the lender whole for those interest payments that they would have earned had you kept that loan until maturity.

So to calculate this prepayment penalty lenders will usually take the difference between the interest rate that you’re currently paying on the loan and the equivalent term yielding us treasury rate and calculating the difference in interest payments between those for the remainder of that loan term and then taking the present value of those values based on the

current equivalent term us treasury rate.

So after all of those calculations, the lender is going to come up with some sort of a prepayment amount oftentimes.

This can be a very expensive way to prepay alone. So avoiding a yield maintenance prepayment penalty is something that you definitely want to consider.

You may also have something called a defeasance clause in your loan. And essentially what that does is it allows the borrower to substitute the real estate as a collateral with a portfolio of us Securities that will generate that same Debt Service.

Now, this isn’t necessarily a penalty but this can be very costly to the borrower in the case that they have to defeat these alone. Now, the third term that you want to know is floating rate debt.

Now floating rate debt just means that the interest rate is going to go up and down based on a predetermined interest rate index. So often times what you’ll see in commercial State today is the 30-day Libor index and that’s going to be the index rate that’s going to move on a monthly basis.

That’s going to decide what those loan payments are actually going to be now on top of that interest rate index.

You usually also have some sort of an interest rate spread that’s going to compensate the lender for taking the risk of lending on your specific real estate deal.

Now oftentimes, you’ll see floating rate debt on construction loans or shorter term loans with a higher degree of risk, but also with a much shorter. Action, so the borrower can get out of the loan much more easily and flexibly now the fourth loan term that you need to be aware of in commercial real estate is called Good News money and good news money is when the bank agrees to give you additional loan proceeds if you end up signing a lease at your property to pay for things like tenant Improvement allowances and potentially leasing commissions as well.

So good news money is a way of securing future funding potentially up to a certain maxy dollar amount, but it can make sure that you don’t have to go out of pocket.

For all of your tenant Improvement or leasing commission costs when you sign a new lease at your deal.

Now. Finally the fifth term is a lockout period and this is going to be really important

because a lockout period is going to tell you a time frame where you’re not able to prepay the loan at all.

So there may be scenarios where you need to sell a property at a certain time, or maybe you get an offer that you can’t refuse or you get into trouble from a cash flow perspective and you want to sell that property during that lockout period you’re not able to pay off that loan.

So before you go into any sort of commercial real estate loan agreement, make sure you know if there’s a lockout period and exactly what that lockout period is so those are five key commercial real estate loan terms that you should know before heading into your next or first commercial real estate investment deal.

Now, if you want to learn more about how all of these terms are put together and actually modeled in a commercial real estate deal analysis.