Commercial real estate loan
Also known as: CRE loan, Property finance, Mortgage loan
A loan against a building and the rent it produces. Almost nothing is repaid before maturity, which is where the risk sits.
1 · SnapshotThe one idea to remember
2 · BeginnerWhat actually happens?
An investor buys an office building or a shopping centre. It costs far more than they have, so most of it is borrowed, secured on the building.
The loan is paid from the rent. Which means the lender is really relying on the tenants — a building with a government department on a fifteen-year lease is a completely different credit from one with a dozen small firms on rolling agreements, even if the two buildings look identical.
The feature that surprises people is that these loans mostly do not get repaid along the way. Interest is paid from the rent and the principal is barely touched. At the end, the whole amount falls due at once, and the borrower repays it by taking out a new loan.
So the loan is really a bet that somebody will lend again in five years' time. That bet is made on the day it is drawn, and whether it pays off depends on a lending market nobody can see that far ahead.
- 1
Underwriting4–10 wks
Valuation, leases, tenants and the building itself are examined; the rent roll is the credit.
- 2
Documentation4–8 wks
Mortgage, assignment of rents, and covenants on loan to value and interest cover.
- 3
Drawdown1 day
The loan funds, usually at a fraction of the appraised value.
- 4
Term3–10 yrs
Interest is paid from rent, with little or no principal repaid along the way.
- 5
Refinancing3–9 mths
The balance falls due in one payment and has to be refinanced, in whatever market exists that year.
The valuation — An appraiser decides. Everything is a ratio to a number one professional produced, and that number moves with the market rather than with the building.
Can it be refinanced — The lending market, years later decides. A loan that repays only at maturity is a bet that somebody will lend again, and that bet is made on the day it is drawn.
Who is on the deal
| Who | Side | What they are actually for |
|---|---|---|
| The borrower | Sell side | Usually a special-purpose company owning one building and nothing else. |
| The lender | Buy side | Has a mortgage and an assignment of the rents, and little else to look to. |
| The tenants | Neither | Pay the rent that services the loan, so their credit is the real credit. |
| The valuer | Neither | Produces the number every covenant is a ratio to. |
| The asset manager | Sell side | Keeps the building let, which is the difference between a performing loan and a defaulted one. |
- Desk
- Structured & Asset Finance
- Security
- A mortgage, plus an assignment of the rents
- The real credit
- The tenants, not the borrower
- Repayment
- In one payment at maturity, by refinancing
- Every covenant is
- A ratio to one valuer's number
What decides whether it completes
Not how hard this is, and not a rating — there is deliberately no total. It says which of five blockers decides whether this transaction happens at all, in the same order on all 70 transaction types so they can be compared. This publication's own reading; see the notice below.
- Pricedecides it
- Financingdecides it
- Approvalbarely applies
- Diligencematters
- Executionmatters
What decides it here. Almost nothing is repaid before maturity, so the loan is a bet that somebody will lend again in five years — a bet made on the day it is drawn. Between now and then everything is a ratio to a valuation that moves with the market rather than with the building.
3 · IntermediateHow it runs in practice
The two ratios
- Loan to value — the loan against the appraised value. It decides how much cushion there is if values fall.
- Interest cover, or debt service cover — the rent against the interest. It decides whether the loan is serviceable today.
The two fail in different circumstances. Values fall in a market downturn even while a fully let building keeps paying comfortably. A building that loses a large tenant breaches cover while values are still fine. Reading which one is under pressure tells you what is actually happening.
Everything is a ratio to a valuation
Both tests, and the loan size itself, are ratios to a number produced by a professional appraiser. That number reflects the market: comparable transactions, prevailing yields, expectations. It moves without the building changing at all, and when it moves down every covenant tightens simultaneously across a whole market.
The rent roll is the document
Who the tenants are, what they pay, when their leases end, and what break rights they hold. A weighted average lease length shorter than the loan is a warning that most of the income has to be re-let before the loan matures — by somebody who will then be trying to refinance at the same time.
Cash traps
Modern loans divert rent into a controlled account when a ratio deteriorates, rather than waiting for a default. Money that would have gone to the owner is held instead. It is a much gentler tool than enforcement and it gives the lender control early, which is exactly when it is worth having.
4 · AdvancedThe numbers & the documents
Why refinancing risk is the whole story
A loan at a moderate ratio on a fully let building is comfortable for five years and then has to be replaced entirely. Three things can make that impossible at the wrong moment:
- Values have fallen, so the new loan at the same ratio is smaller than the old one and the gap has to be found in cash.
- Rates have risen, so the same building services less debt.
- Lenders have retreated from the sector, and there is no new loan at any ratio.
All three tend to arrive together, and all three are properties of the market rather than of the property. This is the single most important thing to understand about this asset class.
What changed the analysis
When the risk-free rate is very low, property yields fall and values rise mechanically — the same rent capitalised at a lower rate is worth more. When rates rise the arithmetic reverses, and it reverses for every building at once regardless of how well let it is. A generation of loans written on one set of yields comes due into another.
That is the mechanism, and it is a description rather than a forecast about any market.
Where it becomes a securitisation
Pools of these loans are financed through securitisation, producing commercial mortgage-backed securities — see the instrument. That adds a layer: the borrower deals with a servicer under a rigid contract rather than with a bank that can exercise judgement, which makes extensions and workouts much harder and is a real difference in outcome.
Development lending is a different animal
A loan against a building being constructed has no rent at all until it is finished, and it has construction risk on top. It is closer to project finance than to this, and it should be analysed that way rather than as property lending with a delay.
The formulas above are standard textbook formulations, simplified for teaching. They explain the mechanism — they are not a valuation tool, and they will not reproduce a dealer’s price.
5 · Desk notesHow people on the deal think about it
Now say it back
Close the page and give Commercial real estate loan in four sentences. It takes a minute and it is the only way to find out whether reading it was enough.
- Who wants what — name both sides and what each one is actually trying to get.
- What has to happen, in order — the three or four stages, not the whole timetable.
- Where the money comes from — cash, new shares, or borrowed; somebody has to fund it.
- What kills it — the ordinary way, not the dramatic one.