What Is Commercial Loan?
Once you cross from 4 units to 5, you leave the residential mortgage world and enter commercial lending. Commercial loans are based on the property's ability to pay—debt coverage ratio (DCR), cap rate, and NOI—not just your personal credit. Terms are typically 5–10 years with balloon payments, and prepayment penalties are common. You'll see portfolio loans (held by the bank) and CMBS (pooled and sold to investors). Non-recourse options exist for strong deals; recourse is standard for smaller or riskier properties.
A commercial loan is financing for properties with 5 or more units (multifamily) or for commercial real estate (retail, office, industrial). Unlike residential mortgages, commercial loans are underwritten on property income and cap rate, with shorter terms and balloon payments.
At a Glance
- What it is: Financing for 5+ unit multifamily or commercial real estate
- Underwriting: Property income, debt coverage ratio, cap rate
- Typical term: 5–10 years with balloon payment
- Recourse: Recourse (personal guarantee) or non-recourse
- Sources: Banks (portfolio), life companies, CMBS
How It Works
Why 5+ units is different
Fannie Mae and Freddie Mac buy 1–4 unit residential mortgages. At 5 units, you're in commercial territory. Lenders underwrite the property, not just the borrower. Your credit matters, but the property's NOI and debt coverage ratio drive the decision.
Debt coverage ratio
DCR = NOI ÷ Annual Debt Service. Lenders typically require 1.20–1.35x. If NOI is $120,000 and debt service is $100,000, DCR = 1.20. The property must generate enough income to cover the loan with a cushion.
Portfolio vs CMBS
- Portfolio: The bank holds the loan. More flexibility on terms, modifications, and workouts. Relationship-driven.
- CMBS: Loan is pooled with others and sold to investors. Servicer handles it. Less flexibility; prepayment penalties (often yield maintenance) are standard. Cheaper rate for strong deals.
Recourse vs non-recourse
- Recourse loan: Lender can pursue your personal assets if the property doesn't cover the debt. Standard for smaller deals and weaker sponsors.
- Non-recourse loan: Lender can only seize the property. Carve-outs (fraud, waste, environmental) still create liability. Available for strong deals with institutional sponsors.
Balloon and prepayment
Commercial loans rarely amortize fully. A 10-year term might amortize over 25–30 years, with a balloon payment at year 10. You refinance or sell before the balloon. Prepayment penalties protect the lender if you pay early—often 1–5 years of yield maintenance or a percentage of the balance.
Real-World Example
Rachel buys a 12-unit apartment building in Indianapolis for $1.2 million. NOI is $72,000 (6% cap rate). She gets a commercial loan for $840,000 (70% LTV) at 6.5% for 10 years, 25-year amortization. Debt service: ~$67,000/year. DCR = 72,000 ÷ 67,000 = 1.07—too low. The lender requires 1.25x minimum.
She negotiates: $720,000 (60% LTV). Debt service: ~$57,500. DCR = 1.25. Approved. Balloon payment at year 10: ~$620,000. She'll refinance or sell before then. Prepayment penalty: yield maintenance for the first 5 years. She plans to hold 7+ years, so the penalty won't apply when she refis.
Pros & Cons
- Enables 5+ unit and commercial acquisitions
- Underwriting based on property performance, not just personal income
- Non-recourse available for strong deals
- Competitive rates for stabilized assets
- Portfolio lenders offer relationship and flexibility
- Balloon payment requires refinance or sale
- Prepayment penalties limit early exit
- Recourse exposes personal assets
- Shorter terms than residential (5–10 vs 30 years)
- More complex underwriting and documentation
Watch Out
DCR minimums: If NOI drops (vacancy, expenses), you can breach the debt coverage ratio covenant. Some loans have financial covenants—breach can trigger default. Maintain reserves and monitor performance.
Balloon refinance risk: When your balloon payment comes due, you need to refinance. If rates are high or the property has underperformed, you may not qualify. Plan 12–18 months ahead.
Yield maintenance: Prepayment penalties in CMBS often use yield maintenance—you pay the lender the present value of the interest they'd have earned. Can be 5–15% of the balance in early years. Model it before you sign.
Carve-outs in non-recourse: Non-recourse doesn't mean zero liability. Fraud, environmental issues, and "bad boy" acts (e.g., voluntary bankruptcy) can trigger full recourse. Read the carve-outs.
The Takeaway
Commercial loans are the gateway to 5+ unit and commercial real estate. Underwriting revolves around debt coverage ratio and cap rate. Plan for the balloon payment and understand prepayment penalties before you close. Non-recourse is a benefit for strong deals; don't assume it—negotiate it.