Commercial Real Estate Loan Amortization Periods ... by Warren Kirshenbaum
Contrary to the manner in which residential mortgages are amortized, which is usually over a 30 year period, commercial mortgages are usually amortized over a shorter period for a variety of reasons, as described below.
The term "amortization" refers to the period of time over which the loan is calculated to pay down to a zero balance. So, if a loan is to amortize over a 15 year period, the payments are calculated in order that the loan principal plus interest be paid down to a zero balance over 15 years.
Traditionally, commercial real estate loans are underwritten using a shorter amortization period, such that, at the end of the term, rather than the loan balance being zero, there is a balloon payment remaining. That balloon payment can be made, but it is traditionally refinanced.
By way of example, a $300,000 residential mortgage, amortized over a 30 year term, at a 5% interest rate, would have monthly payments of principal and interest amounting to $1,610. A $300,000 commercial mortgage amortized over a 10 year period at 5% with a $200,000 balloon payment would have monthly payments of principal and interest of $1,060. What these numbers demonstrate is that the monthly payment on the commercial loan is almost one-third less than that of the residential loan, but the commercial loan matures in one-third of the time, and would need to be refinanced several times of the course of a 30 year term.
The reason for the difference in amortization periods is because commercial loans are underwritten differently than residential loans. Both loan types are underwritten using credit quality and loan-to-value ratios. They differ, however, in that a residential loan is underwritten in a manner that is based upon the borrower's ability to repay the loan. The borrower's income is used as the determinant to underwrite a residential loan, while a commercial loan is underwritten based upon the income from the property itself. Commercial loans are usually subject to a debt service coverage ratio (DSCR). The DSCR is a measure of the cash that a property generates that is available to service its debt, and is calculated by determining the property's net operating income divided by its total annual debt service. If a lender is using a DSCR of 1.15 to approve a loan it means that the property needs to generate 15% more cash than is needed to cover its annual debt service obligations. As the operating costs and income from a commercial property will fluctuate more dramatically than those of a residential property, the amortization period is generally shorter to allow for the loan to be re-sized multiple times over the course of a 30 year term.
In the above example, the annual debt service costs of the commercial property would be $12,720. If the property was a 10,000 square foot industrial warehouse, with a tenant committed to a 5 year lease at $1,500 per month ($18,000 per year), and the operating costs of the warehouse attributable to the property owner amounted to $240/month, or $2,880, then the net operating income would be $15,120. This amount ($15,120) divided by the annual debt service obligation of $12,720 would allow for a DSCR of 1.19, satisfying the lender's underwriting requirements.
The balloon payment on the commercial loan adds an interesting twist to the commercial real estate marketplace, particularly in these economic times. The issue we are facing in the commercial real estate arena is that many commercial loans that are maturing in the next 24 months, or have matured over the past 24 months, have experienced a dramatic drop in value. Many of those loans are, therefore, unable to be refinanced, and with a large balloon payment due, commercial owners are faced with a conundrum. Inject more equity into the property to satisfy the loan-to-value requirements for a refinance, attempt to restructure or “workout” the loan with the lender, hope the lender does not move forward and foreclose, i.e. rely on the kick-the-can–down-the-road strategy, or walk away from the property.
Over the next 24 months, it is expected that there will be a large number of commercial real estate loans maturing that the owners will not be able to refinance. This will lead to an abundance of opportunities to acquire distressed commercial assets at positive valuations for the buyers of those properties.