Real Estate Articles
Basic Terms of Real Estate Debt Financing
Written by Brent Pace for Gaebler Ventures
If you use debt financing on your next real estate purchase, you should be familiar with some of the basic terms your lender may use.
Real estate finance can be a complicated creature.
While all lenders have different requirements and styles, most of them use the same basic terms to describe the loans they are offering. Here is a list and definitions of some of the most common terms you will see when using debt financing to purchase real estate. You should be familiar with these terms and read carefully the requirements associated with each of them.
Secured debt - this term implies that the financing is secured against a piece of collateral, which in this case is the real estate itself.
Term - the term of your loan is the length of the loan. For commercial real estate, the most common term is 10 years, although you can find shorter and longer terms if you desire.
Amortization - the term amortization can have multiple meanings, but in most cases the lender will use the term amortization to describe the length of time it takes the loan balance to reach zero. For instance, a loan with a 30-year amortization and a 10-year term implies that the payments of the loan would be complete after 30 years, although the loan itself only lasts 10 years and then must be re-financed.
Balloon payment - the balloon payment is the principal that is due at the end of the loan term. Referring back to the example above in amortization, if your loan only has a 10 year term but a 30 year amortization, you will still have a huge chunk of principal remaining on the loan. This amount is due as a balloon payment. Typically, the balloon payment is paid off with the proceeds of a new loan when you re-finance the property.
No-prepayment - unlike residential mortgages, the typical commercial mortgage does not allow for pre-payment. You may only make the specified payments on the specified dates. Prepayment can constitute a loss of revenue for a commercial lender, so they like to avoid it if possible. Usually the only option for prepayment is called defeasance. This is where you substitute an alternate asset and stream of cash flows for the ones you are providing. Treasury securities are most commonly used.
Interest only period - some loans may offer an interest only period at the front of the loan. The loan will usually describe specifically the interest only period and then the period when principal and interest payments are made. For commercial developers an interest only period can be extremely valuable as a property is stabilizing. If you are selling units or leasing up a commercial property, the interest only period can be quite helpful.
Bond financing - bond financing is a form of debt financing that can be used on a project. Typically bond financing is feasible when you are working with very long term leases. The most common tenants for bond financed projects are often government tenants, including projects financed in conjunction with a local government entity.
Insurance requirements - It will be common to see insurance requirements in your lending documents. Since real estate lending is secured against the property, your lender is interested in the maintenance and upkeep of the property as well as the insurance. The loss due to fire, earthquake, or any other kind of disaster could hurt a lender as much as the owner.
Recourse - typically real estate financing has been done on a non-recourse basis, meaning the lender can only take the property back if you fail to make payments. Many loans recently have been recourse loans however, where the lender has the option to go beyond the real estate asset to recover payments.
Brent Pace is currently an MBA candidate at University of California at Berkeley. Originally from Salt Lake City, Brent's experience is in commercial real estate development and management. Brent will have tips for small business owners as they negotiate their real estate needs.
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