Commercial real estate offers the opportunity for wealth creation through income-producing property. However, funding that investment depends on the intricacies of commercial real estate loans. One of the most important decision points in this regard is that between a fixed and variable interest rate. This piece will take a closer look at the important differences between the two, guide you in your choice, answer some commercially important questions, and help you determine which one will fit best with your wants and needs for commercial real estate.
Fixed vs. Variable Interest Rates: A Breakdown
- Fixed Interest Rates: The name, in itself, has a meaning that a fixed interest rate is going to bring in stability. The interest rate that gets locked in at exactly the time the loan is originated stays the same throughout the period of time. This, in turn, makes it easier to budget and forecast because your monthly payments will not change with the variations in interest rates.
- Variable Interest Rates: Variable interest rates, on the other hand, are based usually on an index, likely the Secured Overnight Financing Rate, and so can vary. This means that monthly payments can either increase or decrease due to varying market conditions. Normally, a variable interest rate will begin lower than a fixed interest rate, but this does introduce the concept that over time, interest rates could reasonably be assumed to rise steeply.
Choosing the Right Rate for Your Needs
The choice between fixed and variable interest rates depends on your risk tolerance and investment goals. Some other factors that would help you decide are given below:
Market Outlook: If interest rates look to go up in the near future, you can insulate yourself from further increases by locking in a fixed rate now. Conversely, if interest rates are low, then a variable rate may provide upfront savings.
Investment Horizon: Rest easy knowing that you’ve locked in fixed rates for your long-term holds and have planned out the entirety of your loan term. Variable rates may be more suitable for a shorter investment horizon where you are comfortable with possible fluctuations.
Risk Tolerance: Are you comfortable with the possibility of your monthly payments increasing due to interest rate adjustments? Fixed rates are very stable, while variable rates come along with some inherent risk.
How do commercial real estate loans work
This is how commercial real estate loans work:
Understanding Commercial Real Estate Loans
Commercial real estate loans finance the acquisition or improvement of property used for business purposes. This is different from residential mortgages for purchasing a home. This property may include shopping centers, warehouses, office buildings, apartment complexes, and other property types that can be leased out to produce income. They can be to buy new property, renovate existing income-producing property, or refinance existing debt on a commercial property you already own.
Key Differences from Residential Mortgages
Focus on Property Income: Commercial lenders look at the loan against the property’s potential income generation through tenants’ rents, not from a person like in residential mortgages.
Loan to Value Ratio: Commercial loans have generally a lower LTV ratio compared to residential mortgages. This implies that the borrower gives a larger down payment—usually between 20-35%—in relation to the loan amount.
Loan Term and Amortization: Commercial loan terms may be anywhere from 5 to 20 years, and of course the amortization, or the period of time in which the full loan is repaid, is often longer than the loan term.
The process for obtaining a loan
This is similar to a residential mortgage, in which a borrower would apply for a loan with a lender, commonly a bank or a REIT specializing in real estate. The application will include information about the borrower’s business experience and the property that is involved, together with its financial projections. With these and other factors, the lender will assess the viability of the project, the amount that will be lent, at what interest rate, and the conditions under which it is approved.
Security for the Loan
Commercial real estate loans are collateralized by a lien on the property; therefore, in the event of default, the lender is authorized to take possession of the property and sell it off to recover the loss.
Types of Commercial Real Estate Loans
There are various types commercial real estate loans available, each with its own characteristics. Some common ones include:
There are many kinds of commercial loans out there, each with their very own personality. Some of the most common include:
Permanent Loans: These are long-term loans used to finance the purchase or construction of income-producing property.
Construction Loans: Used to finance the development or construction of a commercial property.
Bridge Loans: Shorter-term loans used to finance a property until permanent financing can be secured.
Looking for help?
Commercial real estate loans can be complicated; therefore, consulting with a financial advisor or commercial real estate professional may be proper to determine the best combination of your choice for specific needs and to negotiate the optimum loan terms.
Types of commercial real estate loans
Commercial real estate loans are used to finance an income-producing property, such as an office building, shopping center, or warehouse. Unlike residential mortgages, commercial real estate loans are used by businesses and investors, and they come in many flavors, depending on the needs of a project. Here’s a breakdown of some common types:
By Loan Purpose:
- Acquisition Loans: These are permanent financing solutions used in the purchase of existing properties. They have fixed interest rates and, most importantly, feature amortization schedules—gradual repayment of principal—over 5-30 years. The loan-to-value ratios for acquisition loans are usually 65%-80%, which really shifts the burden towards a hefty down payment by the borrower.
- Construction Loans: As the name suggests, these loans are taken to construct commercial property. Compared to acquisition loans, they have shorter terms and higher rates. They typically roll into permanent financing once the project is complete.
- Development Loans: A development loan is similar to a construction loan in that it funds the early stages of a project in development before actual construction. They provide funding for land acquisition and planning for a project until construction financing can be attained.
- Bridge Loans: These are the shortest-term loans arranged to meet temporary financing needs. They may buy some time to secure permanent financing or cover unexpected costs incurred during construction. Since bridge loans are availed for a short period of time, they are provided at a higher rate of interest.
By Loan Structure:
- Conventional Commercial Loans: These loans are much like residential mortgages available from banks and lenders to purchase stabilized income properties with fixed interest rates and amortization schedules.
- SBA Loans: Government-guaranteed loans provided by the Small Business Administration with very attractive terms to small business owners to purchase or refinance owner-occupied commercial properties.
- Conduit Loans (CMBS Loans): This is essentially a pool of commercial mortgages and sold in the secondary market. Because of the pooling of risk in place, this conduit loan may have lower fixed interest rates but could be endowed with stricter prepayment penalties.
- Hard Money Loans: These are short-term loans at higher interest rates, with much stricter approval criteria, offered by private lenders. They can be a good way to go for investors with low credit scores or those who need fast financing.
Note that this is not an exhaustive list, and there are other more boutique commercial real estate loans that cater to specific property and project needs. It is always recommended to consult with a professional on the type of loan that best fits your commercial real estate goals.
Commercial real estate loan calculator
I can’t directly write a calculator into code, but I can describe one for you—a commercial real estate loan calculator. This calculator is going to provide an estimate of what your monthly payments will be and what the total loan cost is based on your details of the loan.
Here’s what the calculator would look like:
Loan Information:
- Loan Amount: The total amount of money being borrowed for the property.
- Interest Rate: The annual percentage rate charged on the loan.
- Loan term: This is the total number of years for the life of the loan.
- Amortization period: The number of years over which the loan is being paid back. In some cases, this might be different than the loan term.
Additional Options (optional):
- Prepayment penalty: Enter a percentage fee if there is a penalty for paying off the loan early.
- Down payment: Enter the amount of your own money you will put towards the property (affects loan amount).
Calculation Buttons:
- Under that, calculate monthly payment: This button will then compute the monthly payment based on the information provided about the loan.
- Calculate amortization schedule: This button will make a table which includes the breakdown of each payment into principal and interest over the term of the loan.
Output:
- Monthly payment: This will show the estimated monthly payment for your loan.
- Total loan cost: This will show the total amount of money you will repay over the life of the loan, including principal and interest.
- Amortization schedule (optional): This will be a table showing each month’s payment, principal paid, interest paid, and remaining loan balance.
Here are some additional things to consider for your commercial real estate loan calculator:
- Loan-to-value ratio (LTV): The LTV is the loan amount divided by the property value. Some lenders may have LTV restrictions on commercial real estate loans.
- Property taxes and insurance: These are ongoing expenses that you will need to factor into your budget in addition to your monthly loan payment.
By using a commercial real estate loan calculator, you can get a better idea of the affordability of a property and compare different loan options. Remember, this is just an estimate, and you should always consult with a lender to get the most accurate information for your specific situation.
Frequently Asked Questions (FAQs)
Are there any caps on how much a variable interest rate can adjust?
Yes, most commercial real estate loans with variable rates have caps on how much the rate can increase or decrease per adjustment period and over the life of the loan.
Can I refinance a commercial real estate loan from fixed to variable or vice versa?
Yes, under the terms of most existing loans, and further depending on the conditions in the market now, it appears that refinancing is very possible for you; but it does come with costs, which is why it is very important to look at the potential advantages before making a decision.
What else should I be sure to compare in the loan offers besides the interest rate?
Also, greatly important loan terms include the loan-to-value ratio, prepayment penalties, and amortization schedule. Make sure you compare every aspect of loan offers you find.
Conclusion
But what will presumably define the ambition toward your commercial real estate is if you can truly capture the subtle differences in these fixed versus variable interest rates because, with careful thinking on your side regarding your tolerance level toward risk, the investment objective, and your view regarding the market, you can be led to a loan structure most likely to be effective for your long-term financial strategy. Note, however, that a financial advisor experienced in commercial real estate can guide this process.
I am Henry, a professional in commercial financing with more than 10 of experience under my belt in this industry. Over the years, I have committed my tenure to the professional guidance of some of the businesses out there just like yours through the complex truths of a commercial loan process. I have developed such fervent interest and commitment to truly making it possible for many clients to get funding which enables them to develop and grow.
