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Know the Differences Between Commercial and Residential Lending


Commercial Real Estate - Financing 101

By Gregory C. Cassel, CCIM, Commercial Asset Manager, High Associates Ltd.

How does financing your corporate office building compare to getting a mortgage on your home?

To answer that question you need to know the key differences between commercial real estate and residential properties. Commercial real estate consists of income-producing properties used solely for business purposes, such as warehouses, office buildings, retail centers, hotels and apartments. Financing for this type of asset is typically accomplished through commercial real estate loans, which are secured by liens on the property and the income it produces.

Just as with residential loans, banks and independent lenders are actively involved in making loans on commercial real estate. However, insurance companies, pension funds, private investors and other capital sources are also major sources of financing for commercial real estate.

Commercial Loan Characteristics

While residential mortgages are typically made to individual borrowers, commercial real estate loans are often made to business entities (e.g., corporations, developers, partnerships, funds, and trusts). These entities are often formed for the specific purpose of owning commercial real estate and limit the liability to the borrower. An entity may not have a financial track record or credit history, in which case the lender may require the principals or owners of the entity to guarantee the loan. A guarantee provides the lender with additional security beyond the real estate to recover any loss in the event of a default.

When a guarantee is not required, and the property is the only means of recovery in the event of default, the loan is called non-recourse. Non-recourse financing is highly desirable from the borrower’s perspective because it limits liability to the real estate and alleviates recourse to the owners. This is not something you find with residential loans, and is one of the unique aspects of commercial financing.

Another difference is that interest rates on commercial loans are generally a bit higher than on residential loans, which is associated to the added risk of commercial real estate. Along with the higher rates, commercial loans usually involve fees that add to the overall cost of the loan, including appraisal, legal review, loan application, and/or survey costs. These additional costs may be required to be paid up front before the loan is even approved (or rejected), so there is a financial risk to applying for a commercial real estate loan that you do not typically see in the residential market.

Important Ratios

The loan-to-value (LTV) ratio, which is determined by dividing the loan amount by the property value, is the key factor in determining the appropriate loan amount in both residential and commercial financing. However, the thresholds a lender may use vary considerably between loan types. For both commercial and residential loans, borrowers with lower LTVs will generally qualify for more favorable financing rates than those with higher LTVs, because they have more equity invested in the property which equals less risk in the eyes of the lender. High LTVs are allowed for certain residential mortgages; sometimes even up to 100 percent.  Commercial loan LTVs, on the other hand, generally fall into the 65 to 80 percent range.

Commercial lenders also look at the debt-service coverage ratio (DSCR), which compares a property’s annual net operating income (NOI) to its annual mortgage debt service obligation, measuring the property’s ability to cover debt. The ratio is quite simply the income a property generates, after deducting operating expenses, divided by the total debt service payments (including interest and principal). The idea is that the property should generate income in excess of the debt obligation, so the higher the number the better. A DSCR of less than 1.0 indicates a cash flow shortage and is a sign that a property is not producing income levels sufficient to cover the mortgage payment.  In general, commercial lenders look for DSCRs of at least 1.25 to ensure adequate cash flow.

Terms and Restrictions

Home buyers usually finance their properties over very long periods of time, with 30-year mortgages being the most common. Residential buyers have other options available of course; however, longer amortization periods create smaller monthly payments which are highly desirable to residential borrowers. In addition, residential loans are usually amortized over the life of the loan so that the loan is fully repaid at the end of the loan term. Unlike residential loans, the terms of commercial loans typically range from five years (or less) to 20 years, and the amortization period is often longer than the term of the loan.

For example, a lender might make a loan for a term of seven years with an amortization period of 30 years. In this situation, the investor would make payments for seven years of an amount based on the loan being paid off over 30 years, followed by one final “balloon” payment of the entire remaining balance on the loan. The additional flexibility in commercial lending is tied to the individuality of borrowers and the varying cash flows of the underlying properties. Commercial lenders can customize the loan repayment schedule to each borrower’s specific requirements.

In contrast to the flexibility with the term, a commercial real estate loan may have restrictions on prepayment, designed to preserve the lender’s anticipated yield on a loan. If the borrower settles a debt before the loan’s maturity date, they will likely have to pay prepayment penalties which can be significant. Prepayment terms are identified in the loan documents and can be negotiated along with other loan terms in commercial real estate loans. Residential loans do not typically have prepayment penalties and can be paid off at anytime during the term.

Borrowing vs. Income Generation

The bottom line is that with residential loans the lender is primarily looking at the borrower and their ability to repay the loan. With commercial lending it is quite the opposite. The lender will look at the value of the property based on the income it produces as the main determination of creditworthiness. In commercial real estate, it is usually an investor (often a business entity) that purchases the property, leases out space, and collects rent from the businesses that operate within the property. The investment is intended to be an income-producing property, and it’s the income that will repay the debt.

When evaluating commercial real estate loans, lenders do consider the credit strength of the entity (or principals/owners); however, the primary determinates are the operating statements for the property, income tax returns, and financial ratios, such as the loan-to-value ratio and the debt-service coverage ratio.

This article is intended to be an overview of commercial and residential financing. It does not purport to give either legal or financial advice. Before taking any action, you should consult with with your attorney or real estate adviser.

Gregory C. Cassel is Commercial Asset Manager at High Associates Ltd. He  provides portfolio analysis and valuation for High Real Estate Group’s commercial real estate investments.  Mr. Cassel holds a B.S. in economics from George Mason University and a certificate of expertise in commercial real estate finance from the Mortgage Bankers Association of America. (717.209.4091 | gcassel@high.net)