Compound Interest, sometimes called "compounding interest", is when interest is added to the principal amount after each period. The next recurring interest calculation then includes the principal along with the accumulated interest. Because of this, compound interest is often referred to as "interest on interest". This is opposed to simple interest, which only calculates interest using the principal. In the end, compound interest can potentially grow a sum exponentially.

The rate at which compound interest is accumulated is based on the compounding frequency. The more compounding periods there are, the higher the compound interest. Conversely, less compounding periods means less compound interest. That means that $1000 compounded at 10% per year will accrue much less compound interest than $1000 compounded at 5% per year.

The formula to calculate compound interest is as follows:

Compound Interest = Total Future Value amount of Principal and Interest _less_ the present Principal amount.

OR

= P [(1 + i)n – 1]

In these equations, P = Principal, i = nominal annual interest rate (as a percent), and n = number of compounding periods. It is important to remember that if the number of compounding periods is more than once per year, then the values of "i" and "n" must be adjusted in the appropriate manner. The "i" value should be divided by the number of compounding periods per year. In addition, the value "n" represents the number of compounding periods per year multiplied by the loan's maturity period (in years).

Remember that growth is the central purpose of compound interest. So as each compound period ends, the interest from that period is now integrated into the principal amount. This then increases the interest calculation on the next period, and so on, and so forth until the loan is paid in full.

Compound interest can potentially grow a sum exponentially, depending on the compounding frequency. The more compounding periods there are, the higher the compound interest. Since financing greatly increases leverage, it will typically also increase equity multiples, IRRs, and cash on cash returns.

However, the extent to which it will do this depends on factors including interest rates, loan fees, and other expenses. If the levered equity multiple also includes reversion (for example, the sale of the investment), the duration of the holding period is also important, as amortizing loans begin by contributing a greater amount of the payment to interest, slowly increasing the principal contribution over the life of the loan.

The advantages of compound interest in commercial real estate are that it can potentially grow a sum exponentially. The more compounding periods there are, the higher the compound interest. This means that $1000 compounded at 10% per year will accrue much more compound interest than $1000 compounded at 5% per year. Additionally, because you are only paying the interest on the loan, your monthly payments will be lower than if you were paying both principal and interest. This can free up additional cash flow each month.

Compound interest can be a disadvantage in commercial real estate because it can lead to higher loan payments when the amortization period begins. Additionally, if the property's value decreases, the borrower could find themselves underwater on their loan, owing more than the property is worth. Before taking out a loan with compound interest, it is important to speak with a qualified commercial real estate broker to discuss all of the risks and benefits associated with this type of financing.

You can calculate compound interest for commercial real estate financing using the following formula:

Compound Interest = Total Future Value amount of Principal and Interest less the present Principal amount.

OR

= P [(1 + i)ⁿ – 1]

In these equations, P = Principal, i = nominal annual interest rate (as a percent), and n = number of compounding periods. It is important to remember that if the number of compounding periods is more than once per year, then the values of "i" and "n" must be adjusted in the appropriate manner. The "i" value should be divided by the number of compounding periods per year. In addition, the value "n" represents the number of compounding periods per year multiplied by the loan's maturity period (in years).

Remember that growth is the central purpose of compound interest. So as each compound period ends, the interest from that period is now integrated into the principal amount. This then increases the interest calculation on the next period, and so on, and so forth until the loan is paid in full.

You can find more information about compound interest in commercial real estate here.