Cost of debt measures the effective interest and financing expenses on CRE loans, used to assess debt service and investment returns.
Cost of debt in commercial real estate financing represents the effective interest expense a borrower pays on borrowed capital, expressed as an annual percentage. It encompasses the nominal interest rate or coupon, lender spread, amortization schedule, fees and origination costs amortized over the life of the loan, and any prepayment or breakage charges that affect realized cost. In CRE underwriting, cost of debt is central to modeling debt service coverage, project cash flow, and comparing financing options across fixed-rate, floating-rate, or hybrid instruments.
Underwriters, sponsors, and brokers use cost of debt to calculate pro forma debt service obligations and to evaluate whether a property’s stabilized NOI supports the proposed loan. Financial models use the effective interest rate — inclusive of amortized fees and covenant-related costs — to compute DSCR, interest coverage ratios, and cash-on-cash returns. Developers consider cost of debt alongside loan term and amortization when comparing financing offers, because subtle differences in upfront fees or amortization can materially change the cost over the hold period.
Accurately determining cost of debt is vital for reliable underwriting, valuation, and investor returns. Underestimating the true cost can inflate projected distributions and lead to cash flow shortfalls or covenant breaches. For lenders, cost of debt helps in pricing risk and setting appropriate covenants, while for sponsors it informs capital structure decisions, leverage targets, and exit timing. The metric also feeds into WACC calculations and comparisons between debt and alternative financing sources to ensure the financing supports the investment thesis.