Financing real estate has evolved over the years but there really is one primary difference and that relates to the type of property being financed. Is the property a commercial enterprise or is the property used for residential purposes? A commercial enterprise means it’s used for income purposes and is an ongoing business concern. A residential loan is used for housing and typically refers to a 1-4 unit property meaning a single family home, a duplex, triplex or fourplex. Any additional units and the property then fall into the commercial category because the owner(s) use the property both for long term appreciation as well as monthly income. But let’s dig a little deeper and look at the basic differences between commercial and residential financing.
While commercial loans can be in the millions based upon the type of property being financed, residential mortgages typically cover properties where the loan amounts are at or under specific amounts. Conforming loan limits in most parts of the country today are $424,100 and can be higher in areas considered to be “high cost” where the median home values for the area are much higher compared to the rest of the country. California, South Florida, Massachusetts and New York to name a few. Jumbo loans are those to finance residential properties where the amounts being financed are above the local conforming limit. By far there are more residential mortgage loans made each year than any other type of real estate loan.
Valuations for residential properties are based upon the results of an appraisal report completed by a licensed appraiser. With a purchase transaction, the buyers provide an appraisal management company with a copy of the sales contract showing the agreed upon price and terms. The appraisal management company then pulls an approved appraiser and assigns the job. The appraiser will first review public records to research recent home sales of similar properties in the area that have sold within the previous six to12 months. The appraiser will then make a physical inspection of the property. The appraiser will measure the lot as well as the property and draw a sketch showing the individual rooms and dimensions.
The appraiser will then look at other features of the home that might inflate the value of the property. For example, a home might have a recently updated kitchen or had wood floors installed throughout. There can be other adjustments as well such as the property being located on a cul-de-sac or backs up to a green belt. These adjustments are then made and compared to the price-per-square-foot number arrived at with the original research on recent sales. For qualifying purposes, the lender will use the lower of the sales price or the appraised value. When refinancing there is no sales contract. Instead, the appraiser relies on a value the borrowers think their home is worth but relies mainly on recent sales.
Residential Rental Properties
Residential properties can be occupied by its owner or non-occupied. A non-occupied home is considered one where the owner does not occupy the property for more than two weeks per calendar year. Investor loans for rental properties will have slightly higher interest rates compared to financing for a primary residence. Buying rental properties provides the owner with a monthly cash flow as well as enjoying property appreciation over the years of ownership. When buyers buy their first rental property they must qualify based upon carrying both mortgages including property taxes and insurance without the benefit of any rental income, even if the property is currently rented and under a lease agreement. However, once the owners buy a subsequent rental property, the income from the unit can be used to not only offset the mortgage payment but also to provide additional qualifying income. The caveat there is many lenders and banks will require the buyer to show at least two years of owning a rental property, which is verified by providing two years of federal income tax returns, specifically Schedule E.
Commercial Real Estate
When a potential buyer first considers a potential commercial property, one of the first bits of data discovered is the Capitalization or Cap Rate. The cap rate is arrived at by dividing the net income from the property by the property’s purchase price. The higher the cap rate, the better the deal. This is easy to do but if the cap rate is low for the area, low compared to similar properties in the area or even a negative number, it’s probably not a good commercial investment.
For example, monthly rent for a commercial unit is $750 per month or $9,000 per year. If mortgage, taxes, and insurance add up to $3,000 then net income is $6,000. If the property was purchased for $50,000, the cap rate is $6,000 divided by $50,000 = .12, or 12.
Commercial properties are also reviewed by calculating monthly cash flow comparing property expenses with cash flow by what is referred to as the debt service coverage ratio. An investor wants to see a DSCR of around 1.20 or better which means for every $1.00 in debt incurred there is $1.20 in monthly cash flow. The 1.20 ratio is enough to cover the mortgage payment plus associated expenses as well as a monthly profit.
Commercial mortgages also require a down payment amount greater than the minimum required for a residential property. A common down payment minimum for commercial loans is 30% of the sales price of the home, or an 80 LTV, or 80 loan-to-value. Loan amounts can range from $50,000 – $100,000,000+ The value is arrived at by comparing the purchase price of the property with similar commercial projects in the area. If an investor is buying and financing an apartment building with 50 units the commercial appraisal should be able to identify similar apartment buildings in the area with a similar number of units. Due to the variance in commercial property types, the commercial appraisal will take more research and are more expensive compared to an appraisal for a single-family residential property.
Commercial property loans also require the borrowers have good credit as evidenced by credit scores and a review of a credit report. If the buyer is an entity such as a Partnership or LLC, the commercial loan will ask for individual credit reports from all members of the partnership with at least a 25% partnership or LLC. Individual partners and owners in the LLC may also be individually liable for the loan in addition to the partnership or LLC.
Borrowers applying for a commercial loan can also be expected to provide income documentation with their most recent copies of pay check stubs covering a 60 day period and the last two years of all W2 forms. For self-employed borrowers, they can expect to provide two years of federal income tax returns, both personal and business along with a year-to-date profit and loss statement. There needs to be a minimum of two years of self-employment verified.
As it relates to income, credit, and assets, commercial and residential properties are approved using similar methods. Yet when it comes to valuation, this is where they begin to differ. Commercial properties consider the income being generated while a primary residential property is concerned with income, credit, and assets available for a down payment and closing costs and the final value of the home being financed.
Applicants that have questions about any residential or commercial programs can learn more under the loan programs tab above. Please call us at the number above, or just the submit the Request Contact form above to speak with a specialist.