Amortization
Also called Amortization schedule, Amortization term, Principal repayment.
Amortization is the repayment of loan principal through the regular payment, computed over a schedule that is usually much longer than the loan term itself. It is cash leaving the property that never appears as an expense, and the length of the schedule decides how much of it there is.
How it works
Two different periods are in play on almost every commercial mortgage, and confusing them is the most common error in the subject. The TERM is how long the loan lasts, frequently five, seven or ten years. The AMORTIZATION is the schedule the payment is calculated on, usually twenty-five or thirty. A ten-year loan on a thirty-year schedule pays principal for ten years and then owes a balloon balance, which is the entire reason refinance risk exists.
Principal is real cash and it is not an expense. It does not touch NOI, it does not reduce taxable income, and it does reduce cash-on-cash return. What it produces instead is equity: every principal dollar lowers the balance repaid at sale, so it lands in the sale proceeds and in the IRR rather than in a distribution. That is why cash-on-cash falls sharply when a loan starts amortizing while the equity multiple barely moves.
The early payments are almost entirely interest and the mix shifts slowly. On the sample loan the first twelve payments are 85 percent interest and the tenth year's are 71 percent, so the paydown a model credits to years one and two is far smaller than the schedule's midpoint would suggest. Shortening the schedule is the lever that changes this, and it changes coverage at the same time: twenty-five years instead of thirty raises the constant by 52 basis points on an identical rate.
Formula
Annual debt service = the level payment that retires the balance over the amortization schedule, times twelve- Term is how long the loan lasts; amortization is the schedule the payment is computed on. They are rarely the same
- The loan constant is that annual debt service divided by the original balance
- Balloon balance at maturity is the original balance less the principal actually repaid over the term
Worked example
The sample loan. $36,335,000 at 6.35 percent, monthly payments of $226,089.34 on a thirty-year schedule.
| Annual debt service, thirty-year schedulea 7.467% constant | $2,713,072 |
|---|---|
| Year-one interest | $2,295,251 |
| Year-one principal15.4% of the payment | $417,821 |
| Year-ten principal29.0% of the payment | $787,118 |
| Annual debt service, twenty-five year schedulea 7.990% constant | $2,903,301 |
| Cost of the shorter schedule | $190,229 a year |
Five years off the schedule costs $190,229 of annual cash flow at an identical rate and moves coverage from 1.11x to 1.04x on flat NOI. The property is unchanged. The loan is a different loan.
Conventions worth knowing
- Ask for the term and the amortization schedule separately. A term sheet saying thirty years without saying which is ambiguous, and the ambiguity is worth six figures a year.
- Lenders frequently size proceeds on a shorter amortization than the note actually carries. The sizing schedule is the one that governs the loan amount.
The common mistake
Treating principal as an expense, or as free
Both errors are common and they run in opposite directions. Putting principal above the NOI line understates net operating income and therefore the valuation, because amortization is a financing item and NOI is capital-structure blind. Leaving it out of the cash flow entirely overstates distributions, because the money genuinely leaves the account every month. It belongs below NOI and inside levered cash flow, and the equity it builds is collected once, at the sale, as a smaller balance to repay.
Related terms
- Loan constantThe loan constant is annual debt service divided by the original loan balance, expressed as a percentage. It combines the interest rate and the amortization schedule into one number, which is what makes it the right rate to compare against a cap rate.
- Interest-only periodAn interest-only period is a stretch at the start of a loan during which the borrower pays interest and no principal. It raises early cash flow and coverage, and it ends with a step up in debt service that has to be modeled.
- Debt service coverage ratioThe debt service coverage ratio is net operating income divided by annual debt service. A 1.25x means the property produces $1.25 of income for every $1.00 of principal and interest owed, so net operating income could fall by 20 percent before coverage reaches 1.00x and the loan stops being covered.
- Cash-out refinanceA cash-out refinance replaces an existing loan with a larger one and distributes the difference, after costs, to the owner. The new loan is sized by the same three tests that size any loan, applied to the property's income on the refinance date rather than at purchase.
- Loan sizingLoan sizing is the process of determining the maximum loan proceeds a property supports. A lender runs three independent tests, a loan-to-value cap, a minimum debt service coverage ratio at a stressed rate, and a minimum debt yield, and lends the lowest of the three.
- Cash-on-cash returnCash-on-cash return is a year's cash flow after debt service divided by the total equity invested. It measures the current income yield on the money actually at risk, ignoring appreciation and any eventual sale.
Keep reading
Every figure, traced to its source
Altyst computes these in exact decimal arithmetic, not with a language model, and clicking any number shows the formula behind it.