Amortization vs. Loan Term Explained [Real Estate]

Commercial real estate loans are very different than residential home loans, and the terms of these deals can be a lot more complex.

One of the biggest differences on the commercial side of the industry is that the amortization period of these loans tends to be different than the loan term itself, which can have some really meaningful impacts on the economics of a deal.

So to make sure you know both what these differences are and the effects these can have on an investment, this post walks through the amortization period and the loan term in commercial real estate, and the impacts of changes to these on both a lender and a borrower.

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Amortization Period

The amortization period represents the length of time that’s used to calculate fixed monthly loan payments that would pay off the loan in full.

This means that if you have a 30-year amortization period, this will be what’s used to calculate your monthly loan payments throughout the loan term, assuming you’d make equal monthly installments over that 30-year period.

Loan Term

In commercial real estate, most lenders will want their full outstanding loan amount back in just a 3-10 year period, regardless of the amortization period on the loan.

This means that a loan might have an amortization period of 30 years, but a loan term of only 5 years. And when this is the case, this means those monthly payments will stop at the end of five years, and the entire outstanding loan balance will need to be paid to the lender at that time.

Why Would The Amortization Period Extend Beyond the Loan Term?

From a borrower’s perspective, matching the amortization period to just a 5, 7, or 10-year loan term will often result in a huge strain on operating cash flows, and this can often even introduce the need for additional equity investments just to pay debt service.

To use an example here, if we were to look at a property acquired for $10 million at a 6% cap rate, we’d generate $600,000 of net operating income in year one of our ownership period.

But if we also say that this property is financed with a 60% LTV loan at a 6% interest rate, with a loan term of 5 years and an amortization period that’s also 5 years, our annual debt service requirements on the loan would be almost $1.4 million. This means that the NOI our property generates wouldn’t even come close to covering these costs, and investors would need to come out of pocket with the remaining $791,000 per year required just to service the debt.

In this scenario, it really wouldn’t make sense for investors to borrow, and it also wouldn’t make sense for a lender to lend. So, to incentivize lending activity on commercial real estate transactions, this is where lengthening that amortization period can start to come into play.

But in this case, if we were to keep our loan term at 5 years and lengthen our amortization period to 30 years instead, our annual debt service requirements would drop by almost 70%, from almost $1.4 million a year to just over $431,000 a year. This has benefits on both sides.

From a borrower’s perspective:

• This decreases monthly debt service requirements
• This reduces the amount of equity they may need to raise to fund a deal over time
• This increases the cash flow available to distribute to investors on a monthly or quarterly basis

From a lender’s perspective:

• This reduces the borrower’s default risk during the loan term
• This increases the total interest they can expect to collect, all else being equal

The Interest Income Comparison

To show this using that same example, in the 5-year amortization scenario, the lender on the deal would earn just over $959,000 in interest payments over that 5-year term, which represents about 16% of their initial loan funding.

But in the 30-year amortization scenario, that same lender could expect to earn over $1.7 million during that same 5-year loan term, which represents over 29% of their original capital investment.

The Risk: Bigger Balloon Payments

Even though a longer amortization period can be beneficial to both the lender and the borrower, this can also create issues, because with a longer amortization period also comes a bigger balloon payment at the end of that loan term.

In the 5-year amortization period in our example (where that monthly payment is the highest), that outstanding loan balance at the end of the loan term is also going to be zero, because those monthly payments will make sure the loan is paid off in full at the end of 5 years.

However, in the 30-year amortization scenario, over $5.5 million of loan proceeds will remain at the end of the term, and will need to be paid off in one lump sum.

When Balloon Payments Become a Problem

If the value of the property has increased and interest rates have also stayed the same (or even decreased) over the loan term, this usually won’t be a problem. In these cases, the borrower can either refinance the property or sell the property outright to come up with that balloon payment.

But where things can start to get tricky is when the value of the property has dropped, or interest rates have increased over the loan term. In these cases, the borrower typically won’t want to sell, but also can’t easily refinance.

An Example of Refinance Risk

Going back to our example, let’s say that at the end of our 5-year loan term, property values have dropped by 20% in the market from the time these loan proceeds were initially funded, making the current market value of the property just $8 million.

In this case, the borrower won’t want to sell at that price point and lock in a $2 million loss, especially since this represents 50% of their initial equity investment. However, if they want to refinance and hold on to the deal, they might have to raise additional equity just to make that happen.

At an $8 million valuation, the same 60% LTV ratio used for the acquisition loan would produce a refinance loan amount of just $4.8 million. This would be almost $800,000 short of what’s required to pay off the existing loan in the 30-year amortization scenario, which means that the borrower would need to come up with the difference just to pay off the loan.

These types of scenarios are why, although a longer amortization period (or even a long-term interest-only period) can be attractive as a borrower, these things do increase refinance risk at the end of the loan term.

How To Learn More About Key Real Estate Loan Terms

If you want to learn more about how these and other real estate loan terms all play into a real estate investment analysis, make sure to check out our all-in-one membership training platform, Break Into CRE Academy.

A membership to the Academy will give you instant access to over 120 hours of video training on real estate financial modeling and analysis, you’ll get access to hundreds of practice Excel interview exam questions, sample acquisition case studies, and you’ll also get access to the Break Into CRE Analyst Certification Exam, which covers topics like real estate pro forma and development modeling, commercial real estate lease modeling, equity waterfall modeling, and many other real estate financial analysis concepts that will help you prove to employers that you have what it takes to tackle the responsibilities of an analyst or associate at a top real estate firm.