When you enter the fascinating world of commercial real estate, you suddenly encounter an entire new glossary of specialist terms and words. And even if you think you’re well aware of their exact definitions, it might come as a surprise to find that a phrase in commercial real estate (CRE) does not always necessarily mean the exact thing it means in other property markets. This applies to the term “amortization,” which has a much broader spectrum of circumstances and conditions in CRE than it does with regard to residential loans, for example.
To clear the air concerning this aspect, we’ve done some thorough research to try and explain what amortization in commercial real estate truly covers. Here’s everything you need to know:
The Definition of Amortization in Commercial Real Estate
Generally speaking, amortization is the progressive, gradual method through which a loan is slowly eliminated. Since commercial real estate basically means properties which are only used for business purposes, financing one usually involves receiving help in the form of a loan. Whether you’re looking to purchase office space, build a hotel or further develop a shopping mall, these mortgages secured by liens are probably the easiest way to finance your project.
After you receive your commercial real estate loan, you have a set period of time to repay it, and this process is what amortization is all about. Since there are two categories of assets in commercial real estate, they have somewhat different forms of amortization:
Amortization of Tangible Assets
Tangible assets refer to real, substantial products which have a physical form. They have two sub-categories: current assets, like inventory and cash; and fixed assets, which can range from equipment and machinery to tools and office furniture. Tangible assets can also be either short-term or long-term.
Regarding short-term tangible assets, they can simply be written off as a one-time business expense, provided they’re used up prior to the next tax calculation. Long-term assets (more than a year old) on the other hand don’t necessarily need to be deducted at once. They can rather be written off progressively over the course of the asset’s projected lifespan. This is mainly because amortization aims at capitalizing an asset’s cost over the period of its anticipated usefulness.
Amortization of Intangible Assets
Intangible assets, on the other hand, are the kinds of resources which do not have a physical form. These mostly refer to (but are not limited to) trademarks, copyrights, patents and other things which can point to the intellectual property and brand recognition of the company.
As you can imagine, it can be quite difficult to calculate and to classify the value or even the life-span of intangible assets. Nevertheless, businesses are required by the Internal Revenue Service to amortize such assets, so if you obtain one, you’ll need to amortize its cost gradually over time.
Interest, Principal and Amortization Terms
During the amortization process, as you pay off your principal (aka the amount you borrowed), the amount of interest you’ll have to pay steadily decreases as it is calculated on the most recent balance of the principal. In this way, as you continue to pay off your loan, the proportion of the money pays the interest decreases, while the proportion which pays the principal increases.
Commercial real estate loans have a set timeframe, can range from between 3-5 years up to 20 years (or even more in some cases) and the amortization term is usually even more than the loan’s term. And this is where balloon payments come in.
Balloon Loans in Commercial Real Estate
Unlike residential loans, which are completely amortizing, commercial loans are more often not. If, for example, you receive a commercial real estate loan for the fixed term of 5 years with an amortization period of 25 years, you’d be paying your loan for 5 straight years (calculated as if the loan were to be paid off in 25). After this is done, you’d still need to pay the balloon payment, which is usually quite a hefty sum, to balance out the entirety of the loan.
The amount the lender charges is based on the length of the loan as well as the amortization period. If you have a strong credit rating, you might be able to negotiate this amount, but the general rule of thumb is that the longer your loan term is, the higher your interest rate will be.