I've been having some interesting conversations lately with other apartment operators and sponsors in my network.
There's been a lot of chatter about deals "blowing up" – the rise in both interest rates and operating expenses over the last three years has caused distress for many deals.
When these situations come up, you often hear someone say the deal had "bad debt."
But what does that actually mean? What makes debt "bad" versus "good” in commercial real estate?
So today, I want to break down some key CRE debt terms that every passive investor should understand.
Agency Debt: The Gold Standard
Let's start with agency debt – a term you'll hear thrown around a lot in multifamily investing.
These are loans either issued or guaranteed by Fannie Mae or Freddie Mac, and offer lower interest rates, longer fixed-rate terms, and are often non-recourse (meaning no personal guarantee required).
But here's the catch – getting agency debt isn't easy.
The underwriting standards are incredibly stringent. Fannie and Freddie want to see that a property is stabilized and that the sponsor group has successfully executed similar business plans before.
🚩 Red Flag Alert: If you're looking at a stabilized, vanilla value-add deal that's not using agency debt, it’s fair to ask why not. It could mean the sponsor couldn't qualify or is purposefully choosing higher-cost debt for some reason.
Amortization vs. Loan Term
At its core, amortization is simply the period over which a loan would be fully paid off, including both principal and interest payments.
But here's where commercial real estate really differs from your mortgage.
With your house, if you have a 30-year mortgage, the loan term and amortization are the same - you make the same payment every month for 30 years and own the house free and clear.
But in the commercial space, you might see a "5-year loan with 25-year amortization."
This means:
The monthly payments are calculated as if being paid over 25 years
But the entire remaining balance comes due after just 5 years
So that final payment (called a balloon) is usually massive
Generally, the longer the loan term, the better – it reduces refinancing risk and gives more time to ride out any market downturns. A 10-year term is inherently less risky than a 5-year term because of the flexibility to hold through a full market cycle if needed.
🚩 Red Flag Alert: Always ask how the sponsor plans to handle that balloon payment at the end of the term, and if they’ve stressed-tested their assumptions. Will they refinance (what if rates are higher)? Sell (what if the market is down)? Have enough cash reserves (unlikely)?
The LTV Picture
Loan-to-Value (LTV) is simple math: loan amount divided by purchase price.
A $7 million loan on a $10 million purchase = 70% LTV.
While we used to see 80%+ LTVs, now banks aren’t taking on as much risk and have pulled back to 60-65% max.
But here's where it gets tricky – some sponsors layer on additional debt through mezzanine loans or preferred equity. So while the senior loan might show a 65% LTV, the total debt in the capital stack could push that much higher.
🚩 Red Flag Alert: Always ask about the total combined LTV of ALL debt in the capital stack. Higher leverage means less cushion if property values decline. Also ask if any loans are cross-collateralized with other properties – it significantly increases risk to the passive investors and is happening more often than you'd think.
To be clear - having multiple components in the capital stack isn't necessarily a red flag. In today's market, with banks lending less, quality sponsors often need to find creative ways to fill the gap. (In fact, that's exactly what we’re doing in our Private Commercial Credit Fund – helping strong sponsors with good deals access that additional capital they need, while providing our investors in the fund with strong cash flow.)
The key is transparency. A good sponsor will be upfront about the entire capital stack and happy to explain their strategy for managing the additional risk that comes with higher leverage.
DSCR: Another Safety Cushion
The Debt Service Coverage Ratio (DSCR) is also simple math: net operating income divided by annual debt payments
An NOI of $650K with debt service of $500K = 1.30x DSCR.
It essentially tells you how much cushion exists between the property's income and its debt payments. A 1.25x DSCR means there's 25% more cash flow than needed for debt payments.
Depending on the terms of the loan, the lender may be able to call the loan due if a certain DSCR isn’t maintained (almost always no less than 1.25x).
🚩 Red Flag Alert: Ask the sponsor if they've stress-tested the DSCR. What happens if expenses increase or rents decrease? Can the lender call the loan due if DSCR drops below their minimum?
The Bottom Line
I know debt terms aren't the most exciting topic. But understanding them is crucial for protecting your hard-earned capital.
Next time you're evaluating a deal, don't be afraid to dig into these details with the sponsor. Their responses and transparency (or lack thereof) can tell you a lot about their experience and risk management approach.