What it means
Lenders approach these loans from a different angle to residential mortgages. The central question is whether the building's net rental income comfortably covers the loan payments, with the borrower's own strength as a secondary consideration.
That is why the two governing tests are loan to value and debt service coverage rather than income multiples. Terms are shorter and structures are less forgiving than in the housing market.
A typical loan runs for five to ten years but is amortised, meaning repaid in instalments, over twenty to thirty, which leaves a large balloon payment due at the end. Borrowers therefore live with refinancing risk that a homeowner on a fully amortising mortgage never faces.
The loan will carry covenants, which are ongoing promises the borrower must keep. Common ones include maintaining a minimum debt service coverage ratio, keeping loan to value below a stated ceiling, and providing annual financial statements and rent rolls.
Breaching a covenant can trigger a default even when every payment has been made on time. Pricing reflects the risk profile.
Rates are usually higher than residential mortgages, arrangement fees of 0.5% to 1.5% are normal, and prepayment penalties or lockout periods are common because lenders want the interest income they priced for. Personal or corporate guarantees are frequently required for smaller borrowers, so the "non-recourse" label applies mainly to larger institutional deals.
The nuance most borrowers underestimate is the interaction between interest rates and property values. When rates rise, debt service goes up and cap rates typically widen, so the loan gets more expensive at exactly the moment the security is worth less.
That combination is what turns a comfortable refinancing into a difficult one.
In practice
Real-world examples.
Example
A dental group borrows $1,800,000 against a $2,600,000 clinic building at 69% LTV, using the loan to buy premises it had leased for a decade. Its DSCR is calculated on the rent it would otherwise pay, and the covenant is set at 1.30.
Example
A property investor reaches the balloon date on a $4,000,000 loan just as cap rates widen. The building now values at $4,600,000 rather than $5,800,000, so the refinancing lender will advance only $2,990,000 at 65% LTV and the investor must inject $1,010,000 of equity.
Example
A brewery takes a $900,000 commercial mortgage on a taproom, and the lender requires a personal guarantee from the two founders plus a covenant to keep the loan below 70% of value. Annual revaluations become a standing item on the board agenda.
Formula
Calculation
Loan to Value (LTV) = Loan Amount / Property Value
Debt Service Coverage Ratio (DSCR) = Net Operating Income / Annual Debt Service
An investor buys a small retail parade valued at $5,000,000 and borrows $3,250,000 at 6.5% interest, amortised over 25 years with a 7-year term.
LTV = $3,250,000 / $5,000,000 = 0.65, or 65%
The monthly amortising payment on $3,250,000 at 6.5% over 25 years is approximately $21,944.
Annual debt service = $21,944 x 12 = $263,331 (rounded)
The parade produces net operating income of $420,000 a year.
DSCR = $420,000 / $263,331 = 1.59
A lender requiring a minimum DSCR of 1.25 has comfortable headroom here: NOI could fall to $263,331 x 1.25 = $329,164 before the covenant is breached, a drop of about 22% from current income.Case study
Seen in the real world.
Kelbrook Holdings is an illustrative, fictional investor that acquired a suburban retail parade for $5,000,000 with a $3,250,000 loan at 65% LTV. At completion, net operating income was $420,000 against annual debt service of $263,331, giving a DSCR of 1.59 and a covenant threshold of 1.25.
Two years in, an anchor tenant paying $96,000 a year went into administration and the unit stood empty for eleven months. NOI dropped to $324,000, taking the DSCR to $324,000 / $263,331 = 1.23 and breaching the covenant by a small margin. Payments were still being met in full, but the lender was entitled to act.
Kelbrook opened the conversation before the lender did, presenting a signed letter of intent from a replacement tenant and offering to deposit $60,000 into a blocked account until income recovered. The lender granted a temporary waiver. This fictional example shows that in commercial property lending, covenant management often matters more than the ability to pay.
Watch out
Common mistakes.
- Assuming a commercial mortgage works like a home loan. Shorter terms, balloon payments and covenants create obligations that residential borrowers never encounter.
- Budgeting only for the interest rate. Arrangement fees, valuation fees, legal costs and prepayment penalties can add 1% to 2% of the loan to the true cost.
- Ignoring the refinancing date until it arrives. Values and rates can both move against a borrower over a five-year term, and lenders want a plan well before maturity.
Questions
People also ask.
What DSCR do lenders typically want?
Most require at least 1.20 to 1.35, with the higher end applied to riskier sectors, shorter leases or weaker tenants.
Is a personal guarantee always required?
Not always, but smaller borrowers should expect one, since fully non-recourse lending is generally reserved for larger, institutional-quality deals.
What is a balloon payment?
It is the large remaining principal balance due at the end of the loan term, because the payments were calculated over a much longer amortisation period than the term itself.
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