So you’re an experienced investor of residential homes and you’re now interested in investing in your first commercial property. The process shouldn’t be any different, right?
Wrong. The process for securing a commercial mortgage loan differs from that of a residential loan in several significant ways. Investors who are new the commercial arena should take some time to familiarize themselves with these differences so they can feel more confident when it comes time to reach out to potential lender partners.
Here are 3 major differences between commercial and residential loans for real estate investors:
1. The property types
Appraising a residential home is a relatively simple process. Since homes within a neighborhood generally share similar characteristics, lenders can look to nearby comps to get an understanding of the property’s value.
On the other hand, every commercial property is unique. Consider how one city block can include retail strip centers, offices, warehouses, and apartment buildings. Each of these are commercial properties, yet none can be compared with one another during an appraisal.
As a result of this additional level of complexity, commercial appraisals take far longer too complete and are more expensive than residential appraisals.
2. The underwriting
The big difference between commercial and residential loan underwriting can be explained quite simply: residential underwriters work to determine the borrower’s ability to repay the loan while commercial underwriters work to determine whether the property in question generates enough revenue for the borrower to repay the loan.
This means that underwriters must not only review the borrower’s creditworthiness, but also their business’ performance and rental information as well.
One prevalent metric within the commercial mortgage transaction process is the Debt Service Coverage Ratio (DSCR). This metric is calculated using the derived property Net Operating Income – the amount of net income after expenses – divided by the debt service (the principal and interest payments). The objective for the lender is to determine how much they feel comfortable lending based on the amount of income the property generates. Lenders typically have a target ratio of about 1.20, meaning that the property would be required to earn a net $1.20 for every $1.00 of debt payment based on principal and interest only.
If it isn’t already clear, the commercial loan underwriting process involves more work and generally takes longer than that of a residential loan.
3. The terms
The typical residential home loan is packaged as a 30-year mortgage that amortizes over the loan’s full term. One the other hand, commercial mortgage loans commonly include terms of 5 or 7 years, with an amortization schedule that lasts longer than the life of the loan.
Commercial loans are also generally seen as more risky than residential loans. As a result, commercial loans can be more difficult to obtain than residential loans. In fact, the general challenges investors face when attempting to secure commercial mortgage loans with banks has led to the creation of a number of alternative lending sources. These solutions generally offer greater flexibility in exchange for a higher interest rate.
Since the loan terms are shorter, commercial mortgage borrowers must refinance their loans more often than their residential counterparts, especially if they plan to keep their property for a long time. While having to secure a new loan every few years can present a challenge for borrowers, the shorter terms do allow for greater flexibility. The key for commercial borrowers is to create a long-term strategy for their finances so they can stay on top of their mortgage situation. That way, they can focus on securing loans that best meet their specific investment needs.
While there are many differences between commercial and residential loans, some aspects remain the same – regardless of the loan type, the best solution for you will be the one that helps you meet your specific short-term and long-term investment goals. If you’re looking for an ideal lending solution and would like more information, be sure to contact Investment Property Loans today.