The interest rate attached to a loan for commercial real estate directly affects the overall cost of borrowing. That information can influence your decision between different financing options, especially if you’re looking to break into a competitive and potentially profitable sector. High interest rates increase your loan payments and reduce net income and overall returns, so it’s important to carefully assess terms and conditions. In short, the money you put into borrowing will impact the profitability and cash flow you receive from your commercial property.
What is a Nominal Interest Rate?
It’s the percentage of interest that doesn’t include fees or compounding. Lenders often use nominal interest rates when advertising or providing initial quotes for loans because it’s an easier way to compare numbers at a glance. It’s a high-level view of what you can expect to pay each month and can influence your cash projections and return on investment, although it doesn’t reflect all the costs associated with using a CRE loan.
Nominal interest rates are typically based on benchmark rates, which represent the amount of money it costs lenders to acquire the funds for your loan. Economic outlook, inflation projections and credit risk spread, including your creditworthiness, also contribute to interest rate calculations.
What is an Effective Interest Rate?
An effective interest rate on a CRE loan shows the true cost of borrowing as it factors in compounding periods. Compounding is the interest generated on the principal and other accrued interest as well. That value shows you what you’ll actually pay for borrowed capital, which can help you budget for your investment more accurately. There are a variety of compounding schedules, including monthly, quarterly, semiannually and annually. The more frequently it occurs, the higher the cost of your loan.
Effective interest rates typically account for:
- Loan origination fees
- Application and processing expenses
- Underwriting
- Appraisal and legal fees
- Administrative costs
That information allows you to accurately compare different loan rates so you can better project cash flow and make informed financing decisions.
Why Comparing Nominal and Effective Interest Rates Matters
Misleading values: Relying solely on nominal interest rates that lenders advertise may not provide an accurate picture of the total cost of a loan. You can use this type of rate for quick comparisons during your preliminary research into financing options, but it’s crucial to remember it doesn’t account for compounding. That can result in underestimating the total cost of borrowing, negatively affecting your ROI and profit margins.
Understanding the true cost: Effective interest rates account for upfront costs and recurring fees as well as other expenses that may reduce the net loan proceeds. You’ll have a more comprehensive picture of what you’ll pay annually, which is helpful when projecting debt service calculations and investment analyses.
Informed investment decisions: Understanding the exact cost of your loan allows you to determine the net operating income you’ll have at your disposal. You reduce your risk of going over your monthly budget so you can optimize the available funds into your property or other ventures.
Tips for Comparing CRE Loans
- Use effective interest rates when comparing different lending options, especially if the compounding schedules and fee structures differ.
- Calculate the total cost of your loan by adding in upfront fees, closing costs and ongoing administrative charges.
- Pay attention to fixed and variable interest rates. Fixed interest provides more predictable payments, while variable alternatives can increase with market fluctuations.
- Review your potential lender’s experience with different types of commercial properties and loan sizes.
Commercial Property Investment Services from DRK and Company
Finding the right loans to finance a commercial real estate investment opportunity can be tricky. Working with an expert team that knows the Columbus market like DRK and Company can simplify the process. We have an extensive network of lenders who can provide flexible lending solutions based on your property and budgetary specifications. Learn more about our services and contact our team to schedule a consultation.
Until next time,
Sarah Campbell
Director of Commercial Real Estate
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