By Terry Painter/Mortgage Banker
Member of the Forbes Real Estate Council
Commercial loans take three prequalifications. They evaluate the quality of the borrower, the quality of the property's income and the quality of the property itself. If just one of these do not qualify, it will sink your loan.
Three Prequalifications for Commercial Loans
1. The Quality of The Borrower – Since the great recession of 2008, the quality of the borrower is the most important to the commercial lender. Lenders want to see experience in owning the property type, a minimum credit score of 680, and a net worth equal to the size of the loan. Commercial lenders will not allow you to be broke when the loan closes. You will need to have 12 months of mortgage payments in post closing savings, or 10% of the loan amount.
2. The Quality of The Income – Lenders prefer properties that have good historical incomes. Preferably 2 years or more of reliable occupancy and net income. A debt service coverage ratio DSCR (defined further on in this article) is the gold standard for computing if the property has enough income to make the loan payments plus a safety margin.
3. The Quality of The Property – this starts with the quality of the location. Is it in a good neighborhood? Is it in a Primary Market – population 500,000 or more, Secondary Market – population 250,000 or small market 100,000 or under? Cities with larger populations have more diverse economy and more industry and jobs. So this represents a much lower risk to the lender. The physical condition of the property is also important to the lender. If there are too many immediate repairs that need to be done, the lender will either require these to be done prior to loan closing or withhold a portion of the loan to make them.
Who Makes Commercial Loans?
Commercial real estate property is income producing property. It is only used for business purposes rather than for residential purposes. Some examples of commercial realty are multifamily properties, office buildings, retail malls, industrial buildings, hotels and mini-storage properties.
Most residential loans these days are sold on the secondary market and follow Fannie Mae or Freddie Mac guidelines. Banks sell most of their residential loans too. Commercial mortgage sources are still primarily banks. But better deals are often found from non-bank lenders. These include private lenders, pension funds, insurance companies, Commercial Mortgage Backed Security Funds (CMBS), Fannie Mae, Freddie Mac, REIT’s Department of Housing and Urban Development (HUD), and the Small Business Administration’s 504 loan program.
7 Ways Commercial Loans are Different from Residential Loans
1. Commercial Loans Are Made To Ownership Entities, Seldom to the Individual
While residential loans are generally made to individuals, commercial loans are generally these days made to an ownership entity like an LLC. These entities also include corporations as well as limited partnerships.
Entities may be without a credit rating or without a financial history. In such cases lenders could need for the entity owners to guarantee the loan. Having this guarantee gives the lenders an ability to recover the mortgage owed in case of default on the loan.
However there is something called a non-recourse loan. For a non-recourse loan, the lender’s only recourse is the property. The lenders cannot collect the debt from the individuals who own the property.
2. A Difference in Loan Repayment Schedule:
When you look at a residential loan, it is a kind of amortized loan where debt is paid in a time period in installments that are regular.
When it comes to the most preferred home loan it’s the 30 year fixed rate loan, but there are other residential options that include the 25 year 15 and a 10 year loan. For residential mortgages lengthier mortgage periods generally have lesser monthly mortgage payments, and higher total costs. On the other hand, amortization periods that are shorter typically result in bigger monthly payments and lower total interest costs during the life of the loan.
Home loans typically have an amortization period of 30 years. Often the rates are fixed for 30 year so the mortgage is be paid off at the end of the term of the loan.
When it comes to commercial real estate loans, it’s a different story. The loan terms usually range from five to ten years with a balloon payment due at the end of the term. With commercial loans, the longer you fix the rate, the higher the rate. HUD can fix a rate on an apartment building for up to 35 years. Fannie Mae for up to 30 years. Most commercial banks borrow money wholesale and sell it to you retail. For them to get the best cost of funds, they often borrow on a monthly adjustable. For this reason it is risky for them to fix the rate for more than 5 years. This is because if short term rates go the wrong direction they could be upside down and be carrying the loan at a loss.
Often commercial mortgage banks lend on commercial real estate loan with a 10 year term with a rate adjustment period after 5 years. Amortizations on bank loans average from 20 – 25 years. Securitized lenders like Freddie Mac and Fannie Mae have a 30 year amortization. Commercial Mortgage Backed Security loans (CMBS) can fix a rate for 5 or 10 years and have a 25 or 30 year amortization.
On residential loans a big determining factor is the borrower’s credit scores. If they are high, the buyer may be able to negotiate more favorably on the above terms and the rate will be lower. Most conventional and “A” paper commercial loans require a credit score of 680 or higher. Residential loans seldom have a prepayment penalty, where commercial loans almost always do.
3. Ratios Pertaining to Loan to Value:
Here is another way that residential and commercial loans are different. It’s the loan to value ratio, also referred to as LTV. It’s a number that measures the loan value divided by the property value.
A major difference between commercial and residential mortgages is that residential mortgages have higher loan to values – a maximum of 100% financing when it comes to USDA and VA loans. Loan to values are quite a bit lower for commercial loans – usually ranging between 65% to 80%.
Having to do with both commercial and residential loans, the lower the LTV, the better the loan rate. This is because the lower the LTV, the less risk the lender has.
For example, when there is a high LTV such as 90%, if the borrower should default on the property, the lender has less recourse. If there is a low LTV such as 60%, the lender has higher recourse if the borrower defaults on the property.
For commercial loans, some property types have higher risks so that the LTV is lower. Thus for raw land which has considerably higher risk than the vast majority of commercial property types, the loan may have a maximum loan to value which is 65%. Multifamily which has considerably lower risk may have a maximum LTV of 80%.
4. Commercial Loans Have a Debt Coverage Ratio
The debt service coverage ratio (DSCR) makes a comparison between a commercial real estate property’s annual net operating income (NOI) to its annual debt service. The debt service coverage ratio is the annual net operating income divided by its annual debt service. Annual debt service is the total amount of principal and interest paid in a one year period.
The DSCR is of paramount importance because it shows if a commercial property is profitable.
But the debt service coverage ratio pertains to commercial loans not to residential loans. This is because the DSCR has income involved in the ratio. The income is mostly from rent or leases. But residential property does not have income involved.
A property with a DSCR of 1.0 means that for every dollar of net operating income there is nothing left over to make mortgage payments after expenses are paid. A DSCR of 1.25 means that for every dollar of net operating income, there is an additional 25 cents left over for debt service. Commercial mortgage lenders typically look for a DSCR of a minimum of 1.25 in order to be willing to make a loan, because a 1.25 DSCR generally shows enough cash flow.
However, a higher DSCR is generally required for hotels because hotels have unstable cash flows. A lower DSCR are usually for apartment buildings. The DSCR can be as low as 1.15 for these.
5. Interest Rates and Fees for Commercial Loans Versus Residential Loans:
Interest rates for commercial mortgage loans are most often greater than for residential mortgage loans. Also, commercial loans generally have fees adding expense to the loan. These fees include loan application, legal, appraisal, loan origination fee, environmental fees and survey fees.
For commercial loans there are some fees that need to be paid at or before closing, and some fees are put into the loan to be paid on an annual basis. An example of a loan fee that is paid at closing is a loan origination fee of 1 percent.
6. Commercial Loans Have Prepayment Penalties
Commercial loans generally have prepayment penalties. You cannot prepay your loan or most of your loan without a prepayment penalty. Many commercial loans have one or more years at the end of the loan period where there is no pre-pay penalty. For example, you might get a 10 year loan in which there is a prepayment penalty for the first 8 years, and no prepayment penalty for the last 2 years.
Most Commercial loans at banks have a declining prepayment penalty. For example: 5% the first year, 4% the second year, 3% the third year, 4% the forth year.
In contrast residential loans generally have no prepayment penalty, which is a big advantage. Prepayment penalties are charged by commercial lenders as part of the profit they make from the loan.
7. You Can Still Find a Stated Income Commercial Loan
One benefit of commercial lending is that you can still find a stated income loan which does not require tax returns or verification of personal income. There is no debt to income ratio done on these loans. Stated Income Loans have gone away in the residential world after the great recession of 2008.
In summary, there are vast differences between commercial mortgage loans and residential mortgage loans. If you have lots of residential real estate investment experience, do not assume it’s going to be real easy to cross over into commercial real estate investment.
Jumping into commercial real estate and commercial real estate loans without having basic knowledge of both of them could cause a loss of time and money. It really makes sense for you to find out what the loan guidelines are for any commercial loan you apply for to make sure you will qualify.
By Terry Painter/President Apartment Loan Store and Business Loan Store