Commercial vs residential mortgage loans
So you’re a real estate investor. Maybe you’ve bought and flipped a bunch of houses, or even built a few. But now you’ve crossed over 5 units, or into retail, and you’re in commercial loan territory. Everyone has a first commercial loan. To make sure you’re getting a good deal, you need to know your stuff. Below are four key things to look out for compared to a residential mortgage; but first, a primer.
Commercial vs Resi Underwriting
Underwriting for most residential mortgages focuses on two things:
- The borrower’s (or guarantor’s) personal financials.
- The value of a home based on local comps.
When applying for a commercial mortgage as an investor, the underwriting focuses on three factors:
- The borrower’s (or guarantor’s) financials plus portfolio financials.
- The value of the property based on income and a cap rate supported by market comps.
- The borrower’s track record as a property investor.
Commercial lenders underwrite properties like the business that they are. Historical income is really important, as is historical performance of the person in charge. Even then, all the numbers can pan out for that particular property, but if your financial ratios are weak across your portfolio, that will become an issue in underwriting.
The first step is to professionally underwrite the property investment yourself. If that’s outside your area of expertise, find a partner or a consultant who can underwrite the investment to professional standards prior to seeking out financing. It will only put you in a better position to attract favorable terms and get approved quickly.
4 Key Structural Differences
1. Term & Amortization
In a resi mortgage, your loan ends when you finish paying down the entire principal balance. For commercial mortgages, that’s rarely the case. The typical commercial loan term (the amount of time until the full balance is due) is typically shorter than the amortization schedule (the amount of time it would take to pay down the principal with equal payments). Take for example a common five year fixed commercial mortgage. It may be on a 25 year amortization schedule, which means you are paying it back at a rate that would take 25 years to pay it off. But you don’t have 25 years on your term — at the end of 5 years, you need to pay back the full balance (20 years of principal left), which is typically done by refinancing or selling the property.
Understanding the amortization schedule’s impact on your deal metrics is so important, we recommend looking at it first.
2. Term Sheets vs Pre-Approvals
In a resi mortgage setting, you typically get pre-approved for a certain loan amount before attempting to purchase a home. But in commercial mortgage land, you’ll more generally put the property under contract, and then seek financing. That’s because there’s no true “pre-approval” for commercial loans. What you get is a Term Sheet, which is dependent on the financials of the property you’re purchasing. It’s advisable to exercise a level of caution and conservatism about the amount of financing your property will be able to obtain when financing is a contingency.
3. Prepayment Penalties
Commercial mortgages typically sport prepayment penalties, often requiring a borrower to pay an additional percentage on top of the remaining loan amount in order to pay off the loan early. We’ll go into more specifics about prepayment penalties in a subsequent blog post, but suffice it to say that for most permanent, fixed-rate loans, you want to get a loan that you plan to keep through maturity.
4. Recourse
In a residential bank mortgage scenario, the worst case scenario is losing all of your equity and having the bank take back your house. In a commercial loan scenario, there’s more downside if the loan involves Recourse — you could be personally liable for the full loan amount, which in many cases is much larger than your own equity portion.
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