Commercial Mortgage Terms

There are six basic components or financing terms common to all
commercial mortgages: the maturity date, the amortization period,
interest rate or note rate, loan-to-value, pre-payment penalty, and
recourse provision. Collectively, these six components are simply
An Introduction to Commercial Real Estate Loans 25
referred to as “loan terms.” Financing terms or loan terms are usually first introduced or quoted when the lender issues a letter of
intent. A letter of intent is a written preliminary loan proposal providing a summary of each of the six financing terms and conditions
that will be made part of the promissory note. Alternate names and
variations among loan terms often make it difficult to size a loan, so
it’s important that the meaning and relevancy of each financing term
is fully understood before quoting and underwriting a commercial
real estate loan.

Maturity Period

A commercial real estate loan must be paid off in full at some point
in time, in other words the loan eventually matures and ceases to
exist. The phrase “maturity period” refers specifically to the life span
of a loan. Loans never live on in perpetuity. The maturity period of a
commercial real estate loan is very similar to that of a residential
loan, with only a few exceptions. A loan can mature slowly over time,
or it can end abruptly. A loan that has a very long life span and that
matures slowly over time to the point that the loan balance is reduced
to zero is referred to as a fully amortizing or self-amortizing loan. The
maturity period of a fully amortizing loan always equals the length of
the amortization period. A loan that has a short life span and
matures abruptly is referred to as a term loan. The life span or maturity period of a typical term loan ranges from one to fifteen years.
Term loans are not self-amortizing and require a large lump sum
payment at the end of the maturity period, referred to as a balloon
payment. Unlike a fully amortizing loan, the maturity period of a
term loan never equals the length of the amortization period.
The maturity period of a commercial real estate loan is typically
much shorter than a residential mortgage. However, nearly all residential mortgages are basically self-amortizing, so there’s not much
26 Commercial Mortgages 101
more that can be said about the differences. Nevertheless, a short
maturity period always requires a balloon payment. A balloon payment is an indication that the loan is not fully amortizing. The
amount of the balloon payment is usually equal to the amount of the
outstanding balance. It is also important to point out that the calculation of monthly principal and interest is the same for both a fully
amortizing loan and a term loan. The only difference between the
two is the maturity date. For example, the monthly payment of a term
loan with a maturity period of ten years and an amortization period
of thirty years is no different than the monthly payment of a thirtyyear fully amortizing loan. This type of loan is referred to as a 10/30.
The monthly payment of principal and interest for the ten-year loan
is calculated on the basis of 360 months, just like a thirty-year fully
amortizing loan. The only difference is that the ten-year loan will
eventually have to be refinanced. The maturity periods of a typical
term loan are three, five, seven, or ten years. Apartment loans are the
only exception; you can find fifteen, twenty, or thirty-year fully amortizing terms, but rarely will you find a fully amortizing term for a
nonresidential commercial property such as an office building or
retail center.

Amortization Period

The word “amortization” refers to the process of gradually reducing
a debt over time through a series of periodic payments, usually in
increments of calendar months. The length of time it takes to fully
amortize a loan is referred to as the amortization period and is often
set or predetermined by the lender. The calculation of monthly payments of principal and interest is also dependent on this period of
amortization. The period of amortization should not be confused
with the maturity period of a loan. The maturity period of a loan is
actually dependent on the length of the amortization period, not the
An Introduction to Commercial Real Estate Loans 27
other way around. The maturity period of a loan will never exceed the
amortization period.
Periods of amortization for commercial real estate loans can
range from ten years up to forty years, and in the case of construction loans or bridge loans there often isn’t any amortization at all. A
loan without amortization is referred to as an interest-only loan. The
monthly payment of an interest-only loan is pure interest, with no
principal reduction. Most lenders refrain from the use of interestonly loans because of regulatory requirements. Bank examiners do
not like interest-only loans, especially if the cash flow is more than
sufficient to support an amortizing payment. Interest-only loans are
typically reserved for ground-up construction loans and for interim
financings on commercial properties that are in need of significant
repairs or have insufficient cash flow. The average period of amortization is thirty years, or 360 months. The interest portion of a
monthly payment principal and interest compounds monthly, which
is why amortization is stated in months instead of years.

Loan-to-Value Ratios

Loan-to-value ratios, or LTVs, for commercial real estate loans are typically 80 percent or less. Loan-to-value is the relationship, expressed
in a percentage ratio, between the loan amount and the property’s
market value. For example, if a property has a market value of $1 million and the loan is $800,000, then the loan-to-value ratio is 80 percent ($800,000 ÷ $1,000,000 = 0.80 or 80%). Commercial real
estate lenders are much more conservative than residential lenders
and are less willing to risk lending money above 80 percent of a
property’s value. There are many other lenders who are willing to
lend above the 80 percent standard threshold, but this willingness
comes with a price. Lenders who push leverage limits often require
a higher percentage of equity participation in exchange for accepting
28 Commercial Mortgages 101
the extra risk. Equity participation simply means that the lender will
receive a specified preferred return on the extra leverage including a
share of the appreciation in the equity. You may think these are hardmoney lenders, but that is not typically the case, because
hard-money lenders usually lend at lower LTVs.
The word “value” in the term “loan-to-value” usually means the
“as-is” appraised value. It is also important to note that a lender must
use the lower of “as-is” appraised value or actual cost, if the loan is
for the acquisition or purchase of a property. It is important to make
a distinction between cost and value. Cost is the actual purchase price
plus any capital improvements, whereas value is only an appraisal of
value. Lenders recognize this distinction and will always draw attention to the apparent difference between the two values in their underwriting. Specifically, for a purchase loan, the standard 80 percent
LTV is actually 80 percent of the lower of either actual cost or the
appraised value of the property. If the loan is for a refinance and the
borrower has owned the property for at least a year, then cost is not
considered and the appraised value can be used. In general, the practice of lending on the basis of or using the appraised value when the
actual cost or purchase price is lower than the appraised value is a
regulatory violation that commercial banks would rather do without.

Interest Rates

Commercial interest rates quoted by commercial real estate lenders
are determined by applying or adding a margin to a standard index.
The margin is commonly referred to as a spread. A spread represents
the gross profit or gross margin over and above the lender’s cost of
funds. Spreads also represents the gross margin over and above an
alternative investment with an identical maturity period, such as a
five-year or ten-year U.S. Treasury bond. Spreads are expressed in
terms of basis points such as 175 or 200; 100 basis points equal a sinAn Introduction to Commercial Real Estate Loans 29
gle percentage point. For example, a spread of 150 basis points is the
same as 1.5 percent. An index can be a published market rate of interest or yield on a particular government bond such as a ten-year U.S.
Treasury note, or it can be an average of overnight lending rates
among the world’s largest banks. The index and the spread together
make up the whole interest rate. There are only three types of indexes used by lenders: U.S. Treasury yields, the Wall Street Journal prime
rate, and the London Interbank Offered Rate, referred to as LIBOR.
The maturity period of a loan usually dictates how interest rates
are calculated. If the maturity period of a loan is ten years, the interest rate will be based on the corresponding yield of a ten-year U.S.
Treasury bond, referred to as the ten-year Treasury index. On top of
this index, the lender will add its overhead and operating costs, loanservicing fee, and profit margin to create the actual interest rate of
the loan. For instance, if the yield of a U.S. Government ten-year
Treasury note is 3.5 percent, the lender will add an additional interest
rate of 2 percent plus a loan-servicing fee of 0.85 percent to arrive at
an overall interest rate for the loan of 6.35 percent. This example is
simplified, since lenders actually use basis points to calculate retail
interest rates. This is just one illustration of how commercial interest rates are quoted.
Another market index commonly used by lenders instead of a
U.S. Treasury yield is the U.S. prime rate. The U.S. prime rate is the
base rate on corporate loans posted by at least 70 percent of the ten
largest U.S. banks as published in the Wall Street Journal.
7A bank’s
prime rate is the most competitive or the lowest interest rate offered
to its most valuable corporate clients and high-net-worth customers.
Nevertheless, commercial real estate lenders still frequently pad this
rate by adding a premium of 1 or 2 percent in order to establish a
retail interest rate for the loan. Depending on how competitive the
market has become for the best clients, banks may offer loans at the
prime rate without any premium. Other banks use the LIBOR as the
30 Commercial Mortgages 101
index, plus a spread of 2.0 percent to 4.0 percent. LIBOR is the
British Bankers’ Association average of interbank offered rates for
dollar deposits in the London market as published in the Wall Street
Journal.
8 It is an overseas index that U.S. banks like to use. A fourth
market index used by lenders, not yet mentioned, is an interest rate
swap spread. Similar to the other indexes, a commercial real estate
lender will add an additional 1 percent to 3 percent to an interest rate
swap spread. Interest rate swap spreads are derived from complicated derivative contracts. These derivative contracts, which typically
exchange or swap fixed-rate interest payments for floating-rate interest payments, are an essential tool for investors, who use them to
hedge, speculate, and manage risk.

Prepayment Penalty

Commercial real estate lenders make loans because they need to
invest their money in exchange for an anticipated rate of return. This
rate of return is essentially the interest rate that they charge on the
loan. If a lender makes a loan that matures in ten years, the lender
assumes that it will receive without any interruptions monthly payments of principal and interest for the entire ten years. It’s because
of this expectation of the lender that prepayment penalties were created. Prepayment penalties are essentially deterrents to the early or
premature payoff of the loan prior to the maturity date agreed to by
the lender and the borrower.
There are three types of prepayment penalties that are commonly used by nearly all types of commercial real estate lenders. The first
is yield maintenance, which is a very complex algebraic calculation
used by Fannie Mae, conduit lenders, and life insurance companies.
In a nutshell, it means that the earlier you try to pay off the loan, the
higher the penalty. For example, the prepayment penalty on a typical
ten-year loan term that is prepaid within the first five years of the tenAn Introduction to Commercial Real Estate Loans 31
year loan term can range from a steep 6 percent to 10 percent of the
loan amount. Of course, as the loan nears the maturity date, the prepayment penalty diminishes.
The second kind of prepayment penalty is defeasance, which is
mostly used by conduit lenders. Defeasance is actually not a prepayment penalty but a very costly way to pay off the mortgage early.
Defeasing a loan is a very complicated process of substituting one
form of collateral for another so that the bondholders do not lose
their income stream. The bondholders are ultimately the last ones
who end up possessing the mortgage from the original lender via a
commercial mortgage-backed security (CMBS). What is actually happening when a loan is defeased is that the mortgage is paid off but
instead of the cash proceeds going straight back to the bondholder,
the money is actually spent on the purchase of a series of U.S. fixedrate securities (fixed-rate bonds) that provide a stream of monthly
cash flow identical to the stream of principal and interest payments
used to pay the bondholder prior to the release of the mortgage. The
idea behind defeasance is to make it very difficult for the borrower to
pay off the loan early because bondholders are long-term investors.
Defeasance is just as expensive as yield maintenance, involves the
use of lawyers, and can take several months to implement.
The third and least complicated prepayment method is a fixed or
step-down (declining) schedule. This method is the simplest to understand and the least expensive. The prepayment penalty is fixed at a
constant percentage rate for each year during the life of the loan. For
example, a loan with a maturity period that ends within five years
may have a prepayment penalty of 2 percent for each year, but this
is rare. What is more common, in contrast to a fixed schedule, is a
step-down schedule (also called declining prepay). The penalty of a
step-down schedule may start at 5 percent during the first year of the
loan term and then step down to 4 percent during the second year, to
3 percent during the third year, and so forth until the fifth year of the
32 Commercial Mortgages 101
loan. All three prepayment methods usually allow the borrower to
prepay the loan without penalty during the last three or six months
of the loan term. This is referred to as the open period.

Recourse vs. Nonrecourse Loans

The issue of recourse versus nonrecourse loans is always a concern
for borrowers seeking commercial real estate loans. A sophisticated
borrower, especially one who has many partners, usually desires a
nonrecourse loan. The term “nonrecourse” means that the borrower
is not personally liable for any lender’s losses associated with a foreclosure of the property. Essentially, a nonrecourse loan is a mutual
agreement between a borrower and a lender that in the event the borrower defaults on the loan for any reason, the lender’s only legal
recourse is for the sale of the property via foreclosure, even if there
is a loss. However, the borrower is not entirely off the hook if the
lender’s losses are the direct result of nonmonetary defaults such as
fraud and misrepresentation. A recourse loan is the opposite; the
borrower is unconditionally responsible for the full repayment of the
loan and any deficiency or loss incurred by the lender.

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