Key Terminologies in Commercial Real Estate/Hotel Construction Lending

Commercial real estate (CRE) lenders enable hospitality entrepreneurs to fulfill their dreams by offering tailored loan products and solutions. They make it easier for entrepreneurs to seek the right loans by sharing elaborate loan documents.

These loan documents often include several terms and keywords, some of which are unique to commercial real estate lending. These keywords may be new to many borrowers, making it difficult for them to understand these terms and compare loans. In this blog, we are decoding these keywords by explaining key terminologies in commercial real estate lending.

Commonly Used Terminologies in Commercial Real Estate/Hotel Construction Lending

Adjustable-Rate Mortgage (ARM)

Adjustable-rate or floating-rate mortgages enable borrowers to get hospitality loans at variable interest rates. Initially, the borrower pays interest at a fixed rate for a specific period of time. Subsequently, the CRE lender adjusts the interest rate periodically according to prevailing market conditions. Leading CRE lenders offer different types of ARMs – interest-only, hybrid, and multiple payment options.

Amortization

In the CRE lending process, amortization refers to spreading hospitality loan repayment over a specific period. The repayments over the amortization period cover both principal and interest. As the interest is charged based on the outstanding principal balance, the amount of interest decreases as the borrower makes payments. However, we must remember that all hospitality loans are not 100% amortized.

Appraisal

Appraisal refers to the determination of the value of CRE independently and neutrally. CRE lenders usually determine the loan amount based on the appraised value of the asset. Also, they appraise the value of the collateral through licensed appraisers. Professional appraisers value CRE using common techniques or methods like cost, income, and sales comparison.

Bad Boy Carve-Outs

In non-recourse loans, CRE lenders often include the bad boy carve-outs, that helps them to recover up to the value of the mortgaged asset in case the borrower defaults. The clause comes into use, when the borrower becomes a bad boy by committing fraud, misrepresenting information, or misusing funds.

Balloon Payment

As an important payment strategy in CRE lending, balloon payment allows borrowers to close the loan by making a lump sum payment at the end of the loan term. However, the borrower is required to make a smaller monthly payment till making a balloon payment. Hospitality entrepreneurs opt for balloon payment to curb initial costs and maintain a positive cash flow position. However, CRE lenders exercise due diligence during the underwriting process as the borrower makes the balloon payment at the later stages in the loan lifecycle. 

Basis points

As a common unit of measurement, basis points (BPS) refer to one-hundredth of 1% points (0.01). In CRE lending, BPS are used commonly to track the changes in interest rates. CRE lenders adjust interest rates on loans each time the Federal Reserve (Fed) increases or decreases its benchmark interest rates.

Bridge Loans

CRE lenders help hospitality entrepreneurs meet short-term financial needs or leverage immediate opportunities by offering bridge loans. The repayment period of bridge loans usually varies from 12 to 36 months. Hospitality entrepreneurs seek bridge loans as a short-term alternative to conventional construction loans. Lenders meet borrowers’ immediate funding needs by accelerating bridge loan approval and closure. In addition, they offer tailored bridge loans to facilitate property acquisition, repositioning, and stabilization.

Capitalization Rate

CRE lenders use the capitalization rate or cap rate as a profitability metric to measure the expected return on commercial real estate. The capitalization rate is calculated by dividing net operating income by the value of the asset. When calculating the cap rate, decision-makers consider both actual and projected returns. Likewise, they determine the value of the asset based on key factors like property type, location, condition, and durability. The good cap rate varies across lenders and investors. However, a higher cap rate depicts more credit risks and higher returns.

Cash-Out Refinance

As a form of mortgage refinancing, cash-out refinancing enables borrowers to replace an existing hospitality loan with a new one. They often get a new mortgage loan whose value exceeds the preexisting loan amount. CRE lenders establish the new mortgage only after the existing mortgage is paid off using the new loan. They usually provide the differential amount to the borrower in cash. Hospitality borrowers opt for cash-out refinancing to get credit on favorable terms like extended loan terms and lower interest rates.

Credit Report

When evaluating hospitality loan requests, credit analysts determine and establish the borrower’s creditworthiness by analyzing the credit report. The document prepared by a credit bureau depicts the borrower’s credit history as well as the current credit situation. At the same time, it includes the borrower’s personal details, credit accounts, public records, and recent credit inquiries. Major credit bureaus further determine the borrower’s credit score based on real-time information like payment history, credit history, new credit, and amount owed.

Debt Service Coverage Ratio (DSCR)

CRE lenders use DSCR as a common metric to check if the borrower is capable of covering his or her debt obligations. Also, the metric helps them assess the probability of loan default.  The DSCR of a commercial property is calculated by dividing the net operating income by annual debt service payments. 

Net operating income is determined by deducting total operating expenses from the total income. Likewise, annual debt payments include principal and interest payments. Borrowers can raise more credit when the ratio is more than one as the net operating income covers total debt services adequately.

Debt-to-Income Ratio

CRE lenders use the debt-to-income (DTI) ratio as a key metric to decide if the borrower can repay the loan and make interest payments. As the name suggests, the ratio is calculated by dividing the borrower’s total monthly debt payments by their total monthly income. Lenders prioritize borrowers with a lower DTI ratio as they do not spend their income on repaying more loans. Most lenders consider that the borrower can manage debt payments when the DTI ratio is less than 35%.

Distressed Asset

Distressed assets refer to CRE properties that could result in loan foreclosure due to financial difficulties or legal issues. This can occur due to a variety of reasons, including poor financial performance, high vacancy rates, maintenance issues, or the owner’s inability to meet debt obligations. Such properties that are in distress often raise credit risks for lenders. CRE lenders mitigate credit risks by tracking and analyzing distressed assets regularly. At the same time, they help borrowers convert distressed assets into performing assets by providing support like splitting the entire loan into A/B structures.

Equity Capital

Equity capital in commercial real estate refers to the funds invested by owners or investors into a property project, representing their ownership stake. It is the portion of the property’s value not financed through debt, typically comprising the initial down payment and additional cash contributions. 

Equity capital serves as a critical risk buffer for lenders, ensuring that borrowers have a financial stake in the property’s success. For commercial real estate loans, strong equity capital signals financial stability and reduces loan default risk, making it a key factor in underwriting decisions. It also influences the overall loan-to-value (LTV) ratio, impacting the terms and conditions of the financing.

Escrow Account

In CRE transactions, the escrow account enables a neutral third party to control the transfer of funds between the CRE lender and borrower. Management of the account is done through an agent such as a bank or a mortgage firm who ensures that payments are duly made. This account is used to ensure that all parties fulfill their obligations and that the terms of the contract are adhered to before any money or assets change hands. 

Typically, CRE lenders require borrowers to maintain an escrow account to cover property taxes, insurance premiums, or other expenses related to the property, thereby reducing the risk of default. This arrangement provides security and transparency for both the borrower and the lender throughout the transaction process.

Fair Market Value

The fair market value signifies the value of a commercial real estate property for buying, selling, or leasing purposes. CRE lenders determine the fair market value of a property, by considering crucial factors like location, potential for development, and market conditions to determine the loan amount. Likewise, they use fair market evaluation methods like capitalization, replacement cost, sales comparables, gross rate multiplier, and discounted cash flow.

Fixed-Rate Mortgage

Fixed-rate mortgages include CRE loans that have interest rates that remain constant over the period of the loan. To optimize cash flow many borrowers for mortgages take on fixed rates as it allows them to estimate the payments made toward the debt monthly. Yet, this type of mortgage does not allow them to take advantage of certain market conditions such as cuts in the Fed’s rate.

Floating-Rate Mortgage

The cost of a CRE loan, such as a floating-rate or variable-rate mortgage, fluctuates throughout the loan’s life. Interest rates are readjusted every quarter by the CRE lenders of this class of loans. As an example, leading CREs tweak the percentage for floating-rate mortgages each time the Federal Reserve modifies its benchmark rates. Nonetheless, a CRE entrepreneur must take risks when choosing a floating-rate mortgage.

Floor-To-Area Ratio (FAR)

Floor Area Ratio (FAR) quantifies the relationship between a building’s size and its land parcel. It is calculated by dividing the gross floor area by the parcel size. A higher FAR signifies greater building density. This increased density typically boosts the commercial real estate (CRE) market value. Hence,  it becomes easier for CRE entrepreneurs to secure more substantial credit. However, determining a property’s FAR always necessitates careful consideration of local zoning laws and restrictions.

Foreclosure

Foreclosure is a legal process allowing commercial real estate (CRE) lenders to recover debt by selling the borrower’s collateral (typically property) in cases of default. In CRE loan foreclosures, ownership of the mortgaged property transfers from the borrower to the lender. Foreclosure proceedings can be either judicial or non-judicial. To mitigate the impact of foreclosure, leading CRE lenders prioritize alternative solutions, such as allowing borrowers to “cure” the default. This often involves reinstating the loan, typically initiated by sending a legal notice to the borrower.

Graduated Payment Mortgage (GPM)

Graduated Payment Mortgages (GPMs) are a type of fixed-rate mortgage where monthly payments increase gradually over a set period. Initially, borrowers repay the principal, but payments rise progressively over the loan term. CRE lenders support GPMs by offering flexible repayment schedules. However, compared to conventional CRE loans, this financing option typically results in higher overall expenses for entrepreneurs due to the increasing payment structure.

Hard Money Loans

Hard money loans serve as a short-term financing option that enables CRE entrepreneurs to invest in commercial properties. Entrepreneurs often utilize hard money loans to capitalize on immediate investment opportunities or to renovate properties for resale. Securing hard money loans is generally easier than obtaining traditional financing. When evaluating hard money loan applications, lenders prioritize the property’s value as collateral over the borrower’s credit history. To mitigate credit risk, lenders typically charge higher interest rates on these short-term loans.

Loan Syndication  

Loan syndication makes several lenders finance a single CRE project. CRE entrepreneurs seek syndicate loans to get a higher amount of credit. At the same time, loan syndication enables CRE lenders to expand geographic areas or cover specific industries. Lead arrangers play an important role in the loan syndication process by managing loan documents. They decide when and how additional lenders will fund the CRE project according to loan terms.

Loan to Cost (LTC)

Loan-to-cost (LTC) is a crucial metric for Commercial Real Estate (CRE) lenders when evaluating development and renovation projects. It provides a clear comparison between the loan amount and the total project cost. This ratio is calculated by dividing the loan amount by the total project cost.  LTC helps lenders assess the level of risk associated with a project. 

Project costs encompass various expenses, including land acquisition, construction, and soft costs (architectural fees, legal fees, etc.). Higher LTC ratios generally indicate greater credit risk for the lender. To mitigate this risk, lenders typically require borrowers to contribute a larger equity stake in the project.

However, the appropriate LTC ratio varies significantly depending on several factors, including the asset class (residential, office, retail), property location, project type (new construction, renovation), and prevailing market conditions.

Loan to Value (LTV)

Loan-to-Value (LTV) is a critical metric for Commercial Real Estate (CRE) lenders, particularly when evaluating CRE loans. LTV measures the loan amount relative to the property’s appraised value, providing a key indicator of the lender’s risk exposure. 

Calculated by dividing the loan amount by the property’s appraised value, a lower LTV generally signifies a higher level of borrower equity. This lower risk profile typically results in more favorable loan terms for the borrower. 

However, the appropriate LTV ratio varies significantly based on a multitude of factors, including property type (hotel, restaurant), property characteristics (location, age, condition), loan type (construction, permanent), borrower qualifications (credit history, experience), and prevailing market conditions.

Mezzanine Loans

Mezzanine loans are a hybrid form of financing that blends debt and equity characteristics. In the event of a borrower default, mezzanine lenders have the right to convert their debt into equity ownership in the property. This provides them with a degree of ownership and a claim on the property’s value.

CRE entrepreneurs often utilize mezzanine financing to fund acquisitions, renovations, and expansions. Mezzanine loans are considered “junior” or “subordinate” to senior debt (such as first mortgages), meaning they have a lower claim on the property’s assets in case of default. This higher risk position for the lender necessitates higher interest rates.

Mortgage Insurance

Mortgage insurance serves as a crucial risk mitigation tool for Commercial Real Estate (CRE) lenders. By protecting lenders against potential losses arising from borrower defaults, it enhances the security of their investments. Mortgage insurance policies typically cover losses incurred due to borrower default on loan payments, borrower death, or failure to meet other contractual obligations outlined in the loan agreement.

By incorporating mortgage insurance into their lending practices, CRE lenders can significantly enhance the security of their loan portfolios and reduce their overall risk exposure. However, they utilize various types of mortgage insurance policies, including private mortgage insurance, qualified mortgage insurance premium, and lender requirements.

Participation Lending

Participation lending creates opportunities for multiple CRE lenders to fund a single loan. The originating lender usually underwrites and closes participation loans. He or she subsequently sells parts of the loan to other lenders. Participation lending helps CRE entrepreneurs fund higher-value CRE projects. At the same time, the participation of multiple lenders makes it easier for them to minimize credit risks. Leading lenders in the CRE sector diversify their assets by investing in several participation loans.

Prepayment

Prepayment occurs when a borrower repays a CRE loan in full before its scheduled maturity date. Unexpected prepayments can significantly impact a commercial real estate (CRE) lender’s projected yield on the loan. To mitigate this risk, lenders employ several strategies, including lockout periods and prepayment penalties.

Lockout periods restrict early loan repayment, ensuring the lender receives a minimum amount of interest income. Likewise, lenders may charge borrowers a penalty for prepaying the loan early. This penalty helps compensate the lender for the lost interest income and any associated costs. By implementing these measures, CRE lenders can protect their expected returns and mitigate the financial impact of unexpected prepayments on their loan portfolios.

Prepayment Penalty

A prepayment penalty is a fee charged to a borrower who repays a commercial real estate (CRE) loan before its scheduled maturity date. This penalty compensates the lender for the lost interest income resulting from the early repayment. In case of prepayment of a CRE loan, lenders charge penalty in various forms – yield maintenance, defeasance, and step-down.

Yield maintenance requires the borrower to pay the lender an amount that ensures the lender achieves the originally anticipated yield on the loan. Defeasance makes the borrower provide the lender with a portfolio of high-quality, government-backed securities that will generate sufficient income to replace the expected cash flows from the loan.

The amount of step-down penalties decreases over time as the loan approaches maturity. However, the amount of prepayment penalty usually varies according to the outstanding loan amount and remaining loan duration.

Rebranding

Rebranding is a strategic marketing tactic employed by CRE entrepreneurs to revitalize a commercial real estate (CRE) property’s image. This often involves changing the property’s name and potentially its overall brand identity.

Entrepreneurs rebrand their hotels for various purposes – establish a new image, connect with specific audiences, and repair damaged reputations. CRE lenders facilitate rebranding by providing flexible and tailored loans to CRE entrepreneurs.

Recapitalization

Recapitalization refers to changing the existing financial structure of a CRE company by restructuring its debt and equity structure. CRE entrepreneurs use recapitalization as a strategy to accomplish several goals – improve liquidity, reduce interest payment, and gain financial flexibility. When implementing recapitalization, they choose from a variety of approaches – equity recapitalization, debt recapitalization, and dividend recapitalization. They foster debt recapitalization by refinancing existing CRE loans on more favorable terms.

Refinancing

Refinancing allows CRE entrepreneurs to replace their existing mortgage loan with a new one from a different lender or even with themselves. This process provides an opportunity to secure more favorable terms. When refinancing mortgage loans, entrepreneurs usually negotiate with CRE lenders for lower interest rates, longer loan terms, and removing borrowers from the loan contract. 

CRE lenders support mortgage refinancing by allowing borrowers to choose from several options – cash-in refinancing, cash-out refinancing, and rate-and-term refinancing. Smart entrepreneurs decrease monthly payments by refinancing CRE loans at the right time. However, they evaluate costs associated with CRE loan refinancing, including closing costs, appraisal fees, and potential prepayment penalties on the existing loan

Repositioning

Repositioning is a crucial strategy for CRE entrepreneurs to revitalize underperforming commercial real estate (CRE) projects. This involves a comprehensive approach to transforming the property to better meet current market demands and enhance its competitive edge. 

CRE entrepreneurs reposition a CRE project in various ways – improving capacity, adding amenities, repurposing space, implementing cutting-edge technologies, and adopting sustainability best practices. CRE lenders facilitate commercial real estate repositioning by providing tailored bridge loans to CRE entrepreneurs.

SBA 504 Loans

SBA 504 loans, backed by the U.S. Small Business Administration, offer a valuable financing option for CRE entrepreneurs. These loans are specifically designed to support major business investments in fixed assets. CRE entrepreneurs opt for SBA 504 loans to  fund activities like acquisition, renovation, company acquisition, building improvement, and partner buyouts. 

However, the entrepreneur cannot utilize the funds to meet working capital needs, refinance/repay existing debts, and reinvest in CRE.  By providing access to long-term, affordable financing, these loans can play a crucial role in supporting the growth and success of the CRE industry.

SBA 7A Loans

SBA 7(a) loans, backed by the U.S. Small Business Administration, offer a versatile financing option for CRE entrepreneurs. Unlike SBA 504 loans primarily focused on real estate, 7(a) loans provide broader funding capabilities. Entrepreneurs can use the loan to fund activities like purchasing commercial properties, acquiring existing businesses, meeting working capital needs, and covering startup costs. 

CRE lenders usually offer SBA 7A loans as a long-term credit product. The loan amount can go up to 5 million dollars, while the loan tenure can be increased up to 25 years. The easy qualification process makes SBA 7A loans popular with CRE entrepreneurs. However, they can get this loan only after meeting elaborate documentation requirements set by the lender. Also, no entrepreneur can use this loan for investment in commercial properties.

Treasury Rate

The Treasury rate, or yield, represents the interest rate the U.S. government pays on its debt obligations, such as Treasury bills, notes, and bonds. These securities are considered among the safest investments due to the backing of the U.S. government. They further enable investors to get higher ROI by investing in longer-term securities.

In addition to impacting the returns borrowers get, the treasury rate influences the interest rate on real estate and CRE loans. A rise in treasury rates increases hotel capitalization rates directly. CRE lenders adjust the rate of return generated by investing in commercial real estate whenever the treasury rate increases or decreases.

Underwriting

Underwriting is a critical step in the commercial real estate (CRE) lending process. It involves a rigorous assessment of the creditworthiness and risk associated with a loan application, particularly in the CRE sector. When underwriting a loan, CRE lenders consider a wide range of factors, including the property’s cash flow as well as the borrower’s creditworthiness and repayment ability. 

Experienced CRE lenders further mitigate credit risks by keeping in place a multi-step underwriting process. CRE entrepreneurs can navigate the underwriting procedure efficiently by focusing on key factors like comprehensive business data, solid business plans, detailed property analysis, independent property appraisal, and CRE industry experience.

Yield Maintenance/Lockout

To protect their investment and ensure consistent cash flow, commercial real estate (CRE) lenders often incorporate yield maintenance provisions and lockout periods into CRE loans. These measures aim to minimize the risk of borrowers prepaying the loan early, which can disrupt the lender’s expected income stream.

When calculating yield maintenance penalty, lenders consider unpaid principal, original loan interest rate, and current treasury yield. In addition, they restrict borrowers from prepaying a loan by setting lockout periods. These periods restrict the borrower’s ability to prepay the loan for a specified duration. During the lockout period, prepayment is typically prohibited or subject to significant penalties.

Conclusion

CRE entrepreneurs can choose the right loan product and negotiate for better terms by understanding the specialized terminologies used by CRE professionals. This understanding is essential to compare loan products according to their precise needs. As a seasoned CRE lender, AVANA Capital believes that every CRE entrepreneur must make informed decisions. We inform and educate borrowers about our loan products and programs by publishing exploratory blogs regularly.

About AVANA Capital

AVANA Capital is a seasoned hotel financing company with over 20 years of experience in the CRE lending sector. We meet the varying financial needs of CRE entrepreneurs by offering multiple loan products, including construction loans, CRE loans, commercial bridge loans, and SBA 504 loans. Our trailered CRE loans have been helping entrepreneurs fulfill their dreams through brand acquisition, repositioning, and conversion.