How to be Successful in Commercial Real Estate Financing

Success in commercial real estate financing starts with understanding why it is different from residential loans. Unlike residential financing, where the focus is on the borrower’s credit and income, commercial loans prioritize the property’s value, the income it generates, and the stability of its tenants. Lenders look at how well the property performs and the strength of the lease agreements, especially for single-use properties. To understand the profitability and viability of a commercial real estate investment, knowledge of the financial ratios covered in this article for commercial real estate loans is essential.

In this Article

The Differences Between Residential and Commercial Loans

Residential and commercial real estate differ in several key ways, starting with the type of property and how it is used. Residential real estate involves homes, apartments, and other properties designed for living, while commercial real estate includes buildings like offices, retail spaces, and industrial properties used for businesses. The financing also varies significantly. Residential loans focus primarily on the borrower’s credit, income, and personal financial situation, with the property being secondary. In commercial real estate, financing places a stronger emphasis on the property’s value, income potential, and the quality of the tenants. Commercial loans are often non-recourse, meaning the borrower isn’t personally liable, while residential loans typically hold the borrower accountable. Additionally, commercial properties often require more substantial upfront investments and tend to involve longer, more complex contracts due to the larger scale of the transactions.

The Importance of Property Type in Commercial Loans

For commercial real estate, especially single-use properties or facilities occupied by a single tenant, lenders look at several factors. Properties like fast-food franchises, schools, or churches fall into this category. While public companies occupying these properties are often viewed more favorably. Underwriters will consider various questions to assess risk, such as:

• What happens if the business fails? Lenders want to know the potential impact if the tenant goes out of business. A vacant single-use property can present significant challenges for a lender.
• How costly would it be to convert the property for another use? If the property were to lose its tenant, how easily could it be repurposed? For single-use properties, conversion costs can be substantial, adding risk to the loan.
• How long would the property remain vacant? The time it takes to find a new tenant is a key concern. Some properties, especially those with highly specialized uses, may remain empty for extended periods, reducing income potential.
• What happens at the end of the lease? Lenders are particularly interested in the lease structure. A long-term lease with a stable tenant provides more security than a short-term lease, which increases the risk that the property may lose its income stream when the lease ends.

In contrast, multi-tenant properties like apartment buildings are generally considered less risky from a lender’s perspective. With multiple tenants, vacancy risks are lower, and the property is easier to re-rent compared to a vacant large retail space, such as an empty Wal-Mart® store.

Construction and Short-Term Financing

When developing a commercial property it is quite common to get a short term loan to fund the property acquisition and the construction followed by permanent long term financing once the property is leased. Once the property is leased and income-producing, permanent long-term financing is obtained. During the construction phase, conventional lenders like developers to make a cash investment of at least 20% of the project’s value. This investment reassures the lender that the developer is committed and financially capable. Importantly, lenders are not swayed by claims of increased land value, such as a developer who bought land for $1 million but claims it is now worth $3 million. The cash investment is a crucial indicator of the project’s stability.

Funding Sources for Larger Commercial Loans

For larger commercial loans, funding often comes from life insurance companies or through Commercial Mortgage-Backed Securities (CMBS). These loans are packaged by financial institutions and sold as income streams to investors. This securitization process allows lenders to diversify their risk while providing borrowers with access to capital.

Commercial Real Estate Financial Ratios

One of the most important aspects of evaluating a commercial real estate investment is analyzing the financial health of a property through various financial ratios. These ratios, such as Net Operating Income (NOI), Debt Coverage Ratio (DCR), and Cash on Cash Return, help investors and lenders assess the profitability and risks associated with a property. In this guide, we’ll break down the most important commercial real estate financial ratios and how they can be used to make investment decisions.

Net Operating Income (NOI)

Net operating income (NOI) is the net cash generated before mortgage payments and taxes. NOI is calculated by adding the property’s gross rental income to any other income (such as late fees or parking income) and then subtracting vacancies and rental expenses.

Debt Coverage Ratio (DCR)

Debt Coverage Ration (DCR) is also known as the Debt Service Coverage Ratio (DSCR). The DCR measures your ability to pay the property’s monthly mortgage payments from the cash generated by the rental property. Lenders use this ratio as a guide to determine whether the property will generate enough cash to pay rental expenses and whether there will be enough money remaining to pay back the money borrowed.

The DCR is calculated by dividing the property’s annual net operating income (NOI) by the property’s annual debt service. Annual debt service is the annual total of all mortgage payments (i.e. the principal and accrued interest but not escrow payments).

Example: Assume a net operating income of $40,000 and debt payments of $30,000. The DCR is 1.33 ($40,000 ÷ $30,000 = 1.33).

A debt coverage ratio of less than one (e.g. .75) indicates that there is not enough cash flow to pay the property’s rental expenses and have enough money left over to pay the mortgage payments.

This means that the borrower has negative cash flow and will have to subsidize the difference in order to pay the lender.

Obviously, a lender will not be willing to loan you money to purchase a property that does not generate enough cash to pay the back. In the above example, the DCR of 1.33 means that the property will generate 1.33 times (33%) more cash required than what is required to pay the mortgage.

Cash on Cash Return

Cash on Cash Return is probably the most important ratio needed when evaluating the long-term performance of a rental property. It is the property’s annual net cash flow divided by the net investment, expressed as a percentage

Example: If the net cash flow from a property is $40,000 and the cash invested in the property is $200,000, the Cash on Cash return is calculated to be 20% ($40,000 ÷ $200,000). The net investment in the property is the cost of the property minus the amount borrowed.

One way to understand the ratio is to compare it to a return on a certificate of deposit. If the bank pays you an annual return of, say 5%, the 5% is the Cash on Cash return on the deposit.

However, unless the property is owned free and clear, this is not a totally true comparison. The return you get is AFTER the mortgage and all other expenses have been paid. It can therefore fluctuate wildly. Whereas, if you put $200,000 in the bank in a CD you can be certain that you will get the return you expected.

Please note that the Cash on Cash return does not include property appreciation which is a non-cash flow item until the year of sale. Therefore, if you are evaluating a property on a long-term basis, you need to focus more on the annual cash flow as it relates to your investment and focus less on property appreciation.

Capitalization Rate (Cap Rate)

The Cap Rate is a ratio that places a value on a property based on the net operating income (NOI) it generates which allows for a comparison of properties with different Fair Market Values (FMV). The Cap Rate is calculated by taking the rental NOI and dividing it by the property’s FMV. The higher the Cap Rate, the better the property is said to be performing. Note that the Cap Rate is not a computation of an investment return but rather a way of understanding how a property will generate NOI so it can be compared to other properties.

Cap Rate – Practical Use #1

You can use the Cap Rate to value your property. Let’s say that your property generates $30,000 of annual net operating income. Your real estate agent tells you that the Capitalization Rate in your area is approximately 10%. That would mean that the approximate fair market value of your property is $300,000 ($30,000 ÷ .10).

Cap Rate – Practical Use #2

Assume that you are comparing two properties. The first property has a projected NOI of $20,000 and an asking price of $500,000. The second property has a NOI of only $10,000 with an asking price of $110,000. Which one would the Cap Rate suggest is a better investment? The Cap Rate would suggest that the second property is a better investment since the Cap Rate is 9% ($10,000 ÷ $110,000) versus 4% ($20,000 ÷ $500,000).

Loan to Value Ratio (LTV or LVR)

The Loan-to-Value Ratio is the amount of a secured loan or mortgage divided by the fair market value of the property. For example, if your property is worth $100,000 and you have a mortgage balance of $50,000, the Loan-to-Value ratio on your home would be 50%. The LVR helps you quickly determine how leveraged your property is based on the fair market value of the property versus your cost. You can also use the LVR to determine the amount of your equity.

If you have more than one loan secured against your property, add together the outstanding value of each loan in order to calculate the Loan-to-Value ratio. For example, if your home is worth $100,000 and you have a mortgage balance of $50,000, the Loan-to-Value ratio on your home would be 50%. However, if you also have a second secured loan on your home for $25,000, the Loan-to-Value ratio on your home would be 75% ((50,000 + 25,000) divided by 100,000).

To check your LTV, try our online calculator. Click on the calculator to open. Check out all of our FREE online calculators.

Gross Rent Multiplier (GRM)

The Gross Rent Multiplier (GRM) is another way to value and compare properties. Used mostly in the apartment industry, the GRM is much like the Capitalization Rate except the gross rental income rather than the net operating income (NOI) is used to determine the value of a property. The GRM is calculated by dividing the fair market value of the property by the monthly gross rental income.

Example: If the sales price for a property is $200,000 and the monthly gross rental income for a property is $2,500, the GRM is equal to 80 ($200,000 ÷ $2,500).

Internal Rate of Return (IRR)

When an investment creates differing amounts of annual cash flow, a rate of return can be determined by calculating the Internal Rate of Return (IRR). The formula for computing the IRR is very complicated but essentially an IRR is the rate needed to convert (or discount) the future uneven cash flow to equal your initial investment or down payment.

Example: Assume a cash flow of $100 in the second year. Also, assume that in order to generate that $100, you had to invest $500. In this example, you have an outflow of $500 the first year and an inflow of $600 in the second year ($100 earnings plus the $500 return of your initial investment). To convert or discount the $600 back to today’s dollars to equal your initial investment of $500, a discount rate of 20% is required. Thus, your IRR is 20%.

In other words, IRR is the discount rate at which the “net” present value of all future cash flow is zero (discounted future cash flows = starting investment amount). The “net” meaning you subtract your initial investment.

Leveraged vs. Unleveraged IRR

When you use debt to purchase a property, you are using leverage. This affects your Internal Rate of Return (IRR) by showing how borrowing influences your cash flow. By comparing the leveraged IRR (which includes the impact of debt) with the unleveraged IRR (without debt), you can evaluate whether using debt is improving or diminishing the overall financial performance of your investment.

Modified Internal Rate of Return (MIRR)

The Modified Internal Rate of Return (MIRR) is used to correct a significant inherent problem with the IRR calculation. The IRR formula assumes that you are reinvesting the annual cash flow at the same rate as calculated by the IRR. As a result, when you have a property that generates significant cash flow, the calculated IRR will overstate the likely financial return of the property. The MIRR allows you to enter a different rate that is applied to the property’s annual cash flow. Using the MIRR will more closely mimic the real rate of return since operating cash flow is rarely invested at a higher rate than a bank savings rate.

Finance Rate

The finance rate is the annual interest rate paid on borrowed money during periods when the property experiences negative cash flow. This is particularly important when a property’s income doesn’t cover its expenses, including loan payments. A higher finance rate increases the cost of borrowing, making it more difficult to manage a property during tough financial periods.

Reinvestment Rate

The reinvestment rate is the return earned on any excess cash flow generated by the property after covering all expenses. This extra cash can be reinvested either in the property or in other opportunities. A higher reinvestment rate indicates that the surplus is being used effectively to grow the overall return on the investment.

Conclusion

Commercial real estate investments are more complex than residential ones, requiring a deeper understanding of financial metrics, property performance, and market dynamics. Unlike residential loans, which prioritize the borrower’s financial profile, commercial loans focus on the property’s value, income potential, and tenant stability. Lenders evaluate how well the property can generate income and maintain long-term tenant occupancy, making factors like Net Operating Income (NOI) and Debt Coverage Ratio (DCR) critical for securing favorable financing. The larger scale of commercial properties, complex lease structures, and varying risks add further complexity.

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