Commercial Real Estate Finance

When funding larger real estate projects, lenders provide funds for the purchase, development or refinancing of commercial real estate properties. Due to the often significantly higher credit volume and the associated greater individual risk for the lender, the financing of larger real estate properties is more complex than structuring mortgages for private residential homes. Lenders must therefore take into account factors such as market fluctuations, potential commercial tenants for the properties, and other economic developments. The type of property and its expected return will often also be a decisive factor.

Structures and Credit Products in Commercial Real Estate Finance

Commercial real estate loans differ from residential mortgages in that they have shorter terms and amortization periods, as well as higher loan volumes, which are refinanced after first fixed-interest periods have expired. There are various credit check mechanisms for commercial real estate finance. Unlike in the private sector, corporate clients are not simply scored on the basis of their financial situation, but the company as borrower receives a rating based on several rating factors, which may include company-specific factors such as corporate developments and financial structure. The valuation of commercial real estate property is another important aspect when structuring commercial real estate financing and determining their loan terms and conditions as well as their financing structure. For example, the purchase of a first-class residential property in a growing medium-sized town can lead to more attractive credit conditions than seeking a loan for a mixed-use property with a high commercial component in a metropolitan area. The risk of a commercial real estate property is often determined on the basis of the tenant mix, so other approaches and margin calculations of lenders may apply. Corporate real estate loans are structured in different ways and tailored to the needs of the borrower, the project and the respective characteristics of the property. These can include:

• Financing for the purchase and a long-term holding strategy (buy and hold) are usually structured with regular annuity loans. The property's cash flows form the basis for covering interest and repayment.
• Short-term bridge financing is used to provide capital to enable fast reactions in the market, for example, when an investor needs short-term financing to purchase a property but is seeking long-term refinancing as soon as the property has achieved a stable rental situation.
• Regularly reviewing existing financing and taking advantage of refinancing options when interest rate markets change allows for an optimized loan structure and loan terms for the existing real estate portfolio and can additionally free up capital for new investments.

Taking out commercial real estate finance requires a well-prepared financing and transaction process. The focus here is often on the property's income potential, which is determined using key financial figures such as net operating income (NOI), debt service coverage ratio (DSCR) and loan-to-value (LTV). These financial ratios help lenders assess the feasibility of real estate financing for commercial real estate projects.

Important Key Figures and Terms in Commercial Real Estate Finance.

Net Operating Income (NOI): NOI is a measure of the profitability and earning power of a property and represents the difference between the gross operating income and the operating costs of the property. For example, an apartment building with annual gross rental income of €2 million and current operating costs, including maintenance reserves, of €500,000 would have an NOI of €1.5 million (excluding borrowing costs). This key figure helps investors evaluate the cash flow and income potential of a property and is also relevant for determining its value and the general attractiveness of the investment.

Capitalization Rates & Valuation: The cap rate, or capitalization factor of a real estate property, is calculated by dividing the net operating income (NOI) by its current market value or purchase price. For example, for an apartment complex with a net operating income of €600,000 and a market value of €12 million, the cap rate is 20, which corresponds to a return of 5 percent. The purchase price is therefore equivalent to twenty times the rental income, which in turn means that the purchase price will be recouped after 20 years. Higher capitalization rates correspond to low returns or cap rates and usually mean that it takes longer to recoup the investment. Conversely, low capitalization factors pay for themselves more quickly. Both figures are important indicators for assessing the attractiveness and risk of an investment. 

Affordability (debt service capacity) and loan-to-value ratio in commercial real estate finance
Lenders use several key figures to assess the sustainable servicing ability, also known as the debt to service ratio, of a real estate project or investor before providing commercial real estate finance. The debt service coverage ratio (DSCR) indicates the extent to which the income from the property can cover the ongoing debt service of interest and amortization, whereby a DSCR of 1.0 or more indicates a concurrent or positive debt service coverage ratio and a positive surplus. For example, a property with a DSCR of 1.2 earns 20 percent more income than it has to pay in debt service and can thus service a financing with a sufficient buffer. With a higher DSCR, it may also be possible to borrow additional capital. The loan-to-value ratio (LTV) describes the ratio between the loan amount and the value of the property. This value should usually be below the market value of the property in order to provide the lender with a sufficient safety buffer in the event of a foreclosure.