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How Does Commercial Real Estate Financing Work?

How Does Commercial Real Estate Financing Work?

What is commercial real estate financing? How does it work? Why do investors prefer it?

Commercial real estate financing is one of the backbones of the property and financial industry, as well as the economy. 

So, how does it function for borrowers, lenders, and investors? How can you benefit from it?

What Is Commercial Real Estate Financing?

This is lending with real estate as collateral. Money is loaned in exchange for a mortgage lien against a property, which can be seized or foreclosed on in the case of a default. 

Commercial mortgage loans can be made on a variety of sub-sectors of property types. 

They are typically shorter-term loans. Ranging from six months to 25 years. More often, 1-10 years. 

What Is A Commercial Real Estate Loan Used For?

The most obvious use of commercial real estate (CRE) loans is for commercial property.

That may include:

  • Multifamily properties
  • Industrial property
  • Mixed-use properties

Today, these ‘business purpose’ loans are also commonly used to finance single-family investment properties. Such as fixes and flips or rentals. It may be for a single unit or a whole portfolio of 100 or more properties.

What Is A Commercial Real Estate Loan Based On?

The one main difference with CRE loans is that they are for commercial or business and investment purposes. Not personal use, or for properties to live in. 

While borrowers may well provide personal guarantees, and be personally vetted, underwriting and approval for these loans are more based upon the investment.

Experience can be a significant portion of this. Lenders want to see that their borrowers are experienced operators in the space they are borrowing for. They can see the track record, and reduce their risk by lending to more experienced investors and investment firms. 

In terms of valuation and approvals, these loans are often based on factors like:

LTV: Asset-based loans, After Repair Value (ARV), or Loan To Cost (LTC)

Cash Flow: Rents, Net Operating Income (NOI), and Debt Service Coverage Ratios (DSCR)

Why Lenders Prefer Making These Types Of Loans

These types of loans are often preferred by borrowers, as they are designed for investing, and can have more common sense underwriting versus what they will experience at the local bank.

Lenders prefer making these loans to retail home loans as they are easier to collect on. Lenders and lien holders can begin foreclosure and seize collateral in just days in default. Versus months or years on loans on owner-occupied homes. 

Investing In CRE Loans

How does commercial real estate financing work for investors? 

Investors who are simply looking for high returns and passive income yields, with strong downside protection can invest in these loans as well. 

This can be by originating and making these loans to front-line active investors. Or by investing in existing mortgage loan notes. Notes can be flipped or held for income. Sophisticated investors typically prefer to execute this strategy by investing through a debt fund that does everything for them.