CLIENT EDUCATION Residential vs. Commercial
"Probably the most common topic we discuss with new investors is the difference between
residential lending versus commercial lending. Both asset classes are qualified and structured very
differently, so it's important to understand those differences on a high level. Residential lending
standards are considered to finance properties that are 1-4 units residential. However, any
multifamily residential property over 5 units - commercial lending requirements are used."
WHAT ARE THE HIGH LEVEL DIFFERENCES BETWEEN RESIDENTIAL VS. COMMERCIAL?
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LENDERS. Residential loans are financed most frequently by Fannie Mae, Freddie Mac, and
larger banks for jumbo investment property loans. Commercial loans have a wider variety of
potential lending sources for you to compare if you have access, including agency lenders,
banks, credit unions, life companies, debt funds, CMBS conduits and crowdfunding sources.
LOAN STRUCTURE. While residential loans are typically 15, 20 or 30-year fixed fully
amortized loans, commercial loans are hybrid loans. Commercial loans will usually have a 30-
year term and amortization, but the rate will only be fixed for the first 5, 7 or 10 years. After
the fixed period, the rate goes to an adjustable rate. You will want to understand adjustment
terminology and total interest comparison methods.
DOWN PAYMENT. Residential properties can achieve a 25% down payment consistently for
qualified borrowers. Commercial down payments are going to be case-by-case per property
since it’s determined by two property factors – risk and cash flow. The worse the property
net income, the higher required down payment – despite how strong or high salary the
borrower is. The property needs to stand on its own. Average commercial down payment is
35% down as of 2022 and expected to inch closer to 40% down in 2023 in a higher interest
rate environment. Having the resources and experience to provide an adjusted NOI analysis
proposal can help here.
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INTEREST RATES. Commercial interest rates are going to be roughly comparable to
residential rates. Commercial rates as you've learned however are going to be fixed for a
shorter period of time - 5, 7 or 10 years fixed as opposed to 30 years fixed. There are also
other factors to consider including interest only periods and ability to pay down rate. See
our interest rates white paper for what qualification factors and investor-controlled loan
terms move the needle the most.
BORROWER QUALIFICATION. A common misconception is that borrower strength is not a
factor with commercial properties. While its true that the property determines down payment
and primary terms, commercial lenders are still going to have guidelines for liquidity
reserves, minimum net worth, credit, and investment property experience. Some commercial
lenders might not require tax returns or perform global cash flow (DTI equivalent), but this is
not across the board and may not be available for your request.
PROPERTY QUALIFICATION. The property’s in-place cash flow determines mostly
everything. Its NOI directly determines the maximum loan amount and required down
payment. Stronger cash flow also determines the loan conditions available or imposed.
Besides cash flow, a checklist of other items are also evaluated including market &
neighborhood, quality & condition, vacancy, historical operations, performance risk and lease
structures.
PRE-APPROVAL. While residential lenders can pre-qualify or pre-approve you before writing
an offer based on your personal financials, commercial loans cannot be approved until the
end of due diligence process. You will however receive a “Letter of Interest (LOI)” from the
lender with proposed terms and general requirements. While commercial lenders do not
intend to mislead any parties involved, LOI issuance does not have standardized procedures.
The level of pre-screening varies lender to lender, and loan officer to another. Having a solid
understanding of pre-screening or an experienced mortgage broker is very important here.
REPORTS REQUIRED. Like residential loans, commercial loans will also require a property
appraisal report. However, in addition – depending on the lender and property size,
additional reports such as environmental reports, engineering/structural reports or
earthquake risk reports may also be required. Some lenders are more report heavy than
others, and should be considered in your overall loan costs.
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VESTING. Commercial lenders do not have many restrictions on this topic, and will lend
individuals, trusts, LLCs, and corporations. Residential lenders on the other hand are
notorious for not typically allowing entity ownership with their loans. Commercial lenders do
allow this vesting structure, and sometime even require an LLC vesting with the subject
property being the single asset (single asset entity).
RECOURSE. While residential loans are always “non-recourse” meaning that there is no
personal liability attached to these loans, it’s more of a gray area with commercial.
Depending on the loan size, lender type and LTV – recourse or personal guaranty may be
required of the sponsors. Non-recourse loans are available but will have “bad boy carve
outs” which are rare exceptions which trigger liability.
PREPAY PENALTIES. Investors familiar with residential loans will not be used to prepayment
penalties. Prepay penalties are common in commercial loans and impose a penalty fee on the
investor should they sell or refinance before certain dates. Prepay penalty structures come
in many shapes and forms, but the main ones to understand are stepdown structures, yield
maintenance and defeasance. No penalty loans do exist but are less available and usually at
a rate premium. Caveats can be negotiated including an annual paydown allowance (say
20%), and internal refinance waivers.
TIME FRAMES. Probably the most common issue we run into with new commercial purchases
is expected time frames. Buyers familiar with residential loans entering an escrow typically
reach from experience and write 30-day escrows. While short-term bridge loans can
accommodate if needed, most conventional lenders are going to need 45-60 days on
average, and sometimes up to 90 days for less competitive lenders to close the loan. Some
processes can be expedited, but it’s important to understand your preferred lender’s time
frame, seller expectations & flexibility, and average appraisal bids – and have each coincide
with each other when selecting your financing.
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LOAN COSTS. Commercial loan costs are on average going to be, or at least appear, higher
than residential costs. Commercial lenders do not “build costs into the interest rate”, and
instead charge all fees separately as a dollar cost. Property reports (appraisal, etc.) are
going to be more complex and expensive, loan points not financed into the rate, and
miscellaneous fees (processing, loan docs, lender legal) can vary depending on the size and
complexity of the property.
FEE DISCLOSURES. Residential 1–4-unit lending is more regulated than commercial lending.
While commercial is not the wild west, there is much less restriction or expectations here.
Commercial lenders, mortgage brokers and escrow involved in the process, will in good faith
do their best to set accurate expectations on fees for clients – but are not required to follow
any specific procedures or time frames. It is not uncommon for legal fees to increase for
loans that become more involved, appraisal bids to come back higher than expected, or
lenders to increase point fees if undisclosed borrower risk is uncovered during due diligence.
HARBORWEST is very experienced working with new commercial investors to help them
better understand the often times complex process, nuances, risks and rewards of
commercial real estate financing. If you are expecting to be involved with a nationwide
multifamily commercial (5+ units) transaction with a loan amount need above $1,000,000
(so, let's say a benchmark of $1,500,000 purchase price) - we can add a lot of value to your
loan terms and your overall experience. Contact our team to schedule a call, and we'll get
you setup properly. Should you be interested in multifamily (5+ units) financing, but your
investment property won't quite make our $1,000,000 loan minimum - we still got you
covered. California loan minimum start at $500,000 for our team. Below $500,000 we can
at least provide a few great referrals and a lender list from recent market transactions below
$500,000.
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