February 15, 2018
By Terry Painter, Mortgage Banker
Member of the Forbes Real Estate Council
Commercial real estate loans differ in so many ways from residential loans. It is a different world, or you could say "a different planet.” Here are some differences:
1. On a historical basis, commercial loans have been done with concern to the property first and foremost. And residential loans have been done with concern to the borrower. Since the recession though, commercial lenders are just as concerned with the borrower as the property. This is because before the recession when commercial lenders were not strongly concerned with the borrower, many properties went into foreclosure and quite a few banks went out of business.
2. And since the property is such a major concern for the commercial lender, there are 3 things they look for in the property. The net operating income of the property is the most important for the lender. The lender wants to know how profitable the property is. And the net operating income is a key figure in understanding how profitable a property is. This is followed in importance by the condition of the property and location of the property. But, bottom line, if there is not enough income, there is no loan. Again, for residential loans the borrower is the most important factor.
3. If you look at the appraisal of a commercial loan and a residential loan, each is quite different from the other. The appraisal the commercial lender orders has three types of approaches: Two of them are an income approach and a sales comparison approach. At times the commercial lender orders a cost approach. For the residential lender, his appraisal uses the cost approach and the sales comparison approach.
The income approach is the most important approach for the commercial lender. This is because this lender is mostly focused on the net income of the commercial real estate as well as enough margin left that the borrower has. On the other hand, the residential lender is focused on the income that the borrower has – the person who makes the payments.
4. Most of the time residential loans are set up for individual borrowers, whereas commercial loans are frequently set up for business entities including developers, funds, corporations, trusts, and partnerships. Owning commercial realty is frequently the purpose of setting up such entities.
6. A commercial mortgage broker requires in-depth analysis of the finances of the borrower. A residential loans typically require a simple analysis of the borrower’s finances. Thus a commercial lender requires a personal financial statement – which is a very detailed analysis of the borrowers finances, whereas a residential loan requires much less information on the borrower’s finances.
Commercial loans have capitalization rates (cap rates) and residential loans do not. What is a cap rate? It is a key figure that shows how profitable a property is. And it is simple to figure. You take the value or sales price of a property and divide it by the net operating income. So, if a property is on the market for $1,000,000, and the net operating income is $80,000, then you would have a property being sold for an 8 capitalization rate.
7. The lender also looks at the cap rate of the neighborhood where the property is located. This is because if there is a significant difference between the cap rate of the neighborhood and the cap rate of the subject property, it could influence the value of the property.
Some commercial lenders require that the borrower has experience in owning commercial property. Why? Because owning a commercial real estate property is owning a business. And if you have experience in successfully running that type of business – aren’t you less of a risk than someone who doesn’t have such experience. For example, let’s look at an investor who get’s a loan to start a restaurant. Let’s say that he will own the restaurant as well as the land the restaurant sits on. What if he doesn’t get enough customers to pay the mortgage payments and other expenses? The lender could very well have a big financial hit. Compare this to the level of risk a residential lender has for a borrower who just has a single residence of their own.
If you get into ownership of commercial real estate property, keep in mind that you are owning a business – it’s not a passive investment which quite a few new investors think they are getting into. That restaurant owner has many responsibilities – getting the restaurant functioning with the right equipment and supplies, hiring, advertising, managing, accounting, legal, etc.
Even if you own a simple 10 unit apartment building, you have many responsibilities that take time, knowledge and effort – selecting tenants, handling problem tenants, repairs, needed capital improvements, legal, accounting, etc. And if you have professional property management, you need to manage your property manager. Why because some property managers become lax, and the property goes seriously downhill with vacancies, disrepair, problem tenants, etc. Worse, some property managers steal money from the owner’s bank accounts.
8. A commercial loan works in reverse to a residential loan for interest rates. For residential loans generally the higher the term for the loan, the lower the interest rate. For commercial loans generally, the higher the term of the loan, the higher the interest rate. Thus, a 5 year term commercial loan will have an interest rate quite a bit lower than a 20 year term commercial loan.
9. For residential loans, the amortization period is equal to the term of the loan. Thus, the loan is fully paid off at the end of the amortization period. The loan term for a commercial loan is almost always fewer years than the number of years of amortization.
The range of years for the term of a commercial loan is usually around 3 years to 20 years. A typical commercial loan has a 5 or 7-year term. And the amortization period typically is 20 years, 25 years, or 30 years. What happens at the end of the term? Quite often, a borrower will refinance the loan. Or a borrower might sell their property before the loan expires. Another choice is that some lenders permit that the loan be transferred and there is a fee for transferring. But, at the end of the term, the borrower owes what is called a balloon payment – the final loan payment. A balloon payment is the balance left on the loan, and it must be paid off at the end of the loan term.
10. Another difference between commercial and residential loans is that commercial realty is real-estate that produces income, and it is used only for purposes of business. This includes mini-storage, hotels, multifamily, retail centers, and hospitals. Residential loans are usually not for business purposes.
11. Another difference between commercial loans and residential loans is in loan to value (LTV). The loan to value is the quotient of the amount of the loan divided by the value of the property. Amount of loan/value of the property. Thus, an 80% Loan to value on a million dollar property, would mean that the borrower is getting an $800,000 loan on a million dollar property. $800,000/$1,000,000 = 80% loan to value (LTV)
The difference between commercial loans and residential loans regarding loan to value is that with residential loans you can do up to 100% financing on some kinds of residential loans – namely USDA and VA. And you can get up to 95% financing on Fannie Mae and Freddie Mac.
LTVs for commercial lending usually range from 65% to 80%. There are some commercial loans that have higher loan to values. The percentage of loan to value on a commercial property frequently depends on the type of property. Raw land may get a maximum of 65% LTV, whereas apartment financing can frequently allow up to 80% LTV. Why? The level of risk of raw land financing is much higher than that of multi-family financing.
12. Another important difference is that the interest rate for commercial lending is most often greater than that for residential lending. In addition, fees are usually part of the cost for commercial loans. These include the appraisal, loan application fee, legal, and loan origination.
13. Prepayment penalties are frequently required for commercial loans. This helps the lender get the amount of money on a loan that is anticipated. The interest over a period of years is an important part of the income for the lender, and the loan is set up to make sure that the lender gets that income. Thus, in case the investor wants to get out of the loan early, there is a pre-payment penalty which helps the lender get their anticipated income anyway. Prepay is frequently set up as a declining pre-pay. Thus, a five-year fixed loan may have a declining prepay of 5, 4, 3, 2, 1.This means that the pre-payment penalty for the first year is 5%, second year 4%, third year 3%, etc.
14. There is a difference between commercial lending and residential lending when it comes to multifamily financing. And that is residential loans are given for apartment buildings of 1 to 4 units. Commercial loans are given for apartment buildings of 5 to an unlimited number. Yes, that is correct. Fannie Mae’s commercial apartment loan program has no limit on size of loan. Therefore, no limit on number of units.
There are some people who do not know this distinction in number of units. For example, they think that if they own a 4 unit property it is a commercial property. Not so. It needs to be 5 units and above to be a commercial property.
Now where it can get confusing is when you get into mixed use property. Mixed use property has both multifamily and commercial property. Thus, a mixed use property might have 3 multifamily units, and a little grocery store. That is a commercial property because one of the properties is commercial – namely the grocery store. Thus, when considering mixed use property, it is automatically commercial because it has at least one piece of commercial property.
15. Another difference between a commercial real estate loan and a residential real estate loan is that commercial lenders are concerned with the Debt Service Coverage Ratio (DSCR). Residential lenders are not concerned with that. The Debt Service Coverage Ratio looks at the ability of a property to cover payments. But not just cover payments, their needs to a margin – extra money left over after payments are made. Thus, the debt service coverage ratio makes sure there is enough profit for making the payments as well as having enough margin. Why is a margin important? Because if a borrower had only just enough profit coming in to make payments, the borrower could fall short for unforeseen expenses – plumbing, electrical, roof, etc. – problems which depending on the property could run into the 10’s of thousands. Another unforeseen cost is the loss from a drop in vacancy that can come from deployment of the military, layoffs of workers in the area, etc.
The debt service coverage ratio (DSCR) is the quotient of the annual net operating income (NOI) divided by the annual payments which are principal and interest. This ratio gives the commercial lender the amount of risk involved in the loan. If a property has a net operating income of $130,000 and annual payments of $100,000, the DSCR is 1.30. $130,000/$100,000 – 1.3. This figure lets the commercial lender see how profitable the property is, and what the maximum size loan he can give – the basis of this being the cash flow of the property. For a 1.3 debt service coverage ratio, there is for every dollar of loan payment, 30 cents for margin.
In summary, there are quite a few differences between commercial loans and residential loans. To summarize some key points: For a commercial real estate loan, it is usually an investor (most often a business) that buys the property, leases the property, and collects rent from the business tenants who operate their businesses within the property. A residential real estate loan is much simpler. It is usually an individual who buys the property for the purpose of living there, and that’s it.
Some other ways that commercial loans differ from residential loans: For commercial loans, the property is a major factor in making the loan. And concerning residential loans, the borrower is the major factor. Commercial loans are often made to business entities, whereas most of the time residential loans are made to the individual investor. For commercial loans interest rates tend to work in reverse to residential loans. The interest rates for a commercial loan tend to go up as the term increases. For a residential loan, interest rates tend to decrease as the term of the loan increases. Also, a commercial lender will do an in-depth analysis of the finances of the investor, whereas a residential lender will tend to do a simple analysis of the finances of the borrower.
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