Posted almost 4 years ago

Key Differences Between Residential and Commercial Loans

The most popular way to finance a property is to get a loan from a lending institution.

It works like this: you find a property, and then apply for a loan for the money to cover some or all of the cost to purchase the property. The loan on a property is called a mortgage or debt service. Every month you pay back the interest and some of the principal on your loan.

There are residential loans (for 1-4 unit residential buildings) and commercial loans (for every other type of real estate: 5+ units, retail, industrial, hotels, land, etc.). These are the key differences between them:

1. Who can borrow?

Residential Loans (1-4 units):

In residential loans, only individuals can borrow.

The banks will look to the income, credit, and debt of the borrower to assess if they are financially fit enough to get a mortgage.

Banks want to make sure that you, as the borrower, have the income to pay for the mortgage. They generally want your mortgage payment to be no more than 30% of your gross monthly income. They will also check to see about the source of the income. Typically, they prefer that you’ve been in the same job for over 2 years. This is evidence of your financial stability. For self-employed professionals, you need to show two years of tax returns and sufficient income for a loan.

With regards to credit, banks typically look for a FICO score of over 720 to access the best rates. You may still qualify for a mortgage with a lower credit score, but you will pay higher rates. If your score is below 620, you may need a much higher down payment and/or you may be denied.

Banks will assess your debt-to-income ratio. In other words, they want to know what your total debt (including car loans, credit card bills, student loans, etc.) is in relation to your gross monthly income. Your debt-to-income ratio should generally be no more than 36% of your gross income. If it’s too high, consider paying down your credit cards and other debts.

Commercial Loans:

In commercial loans, entities (e.g., Limited Liability Corporations (LLCs)) can also purchase the property and borrow money to do so.

Why is that important? An entity can provide certain layers of liability protection for the owners. So, for example, if someone slips and falls on your property, you will not personally be liable.

There are also certain tax benefits to using an entity. For example, an entity may pay income taxes at a lower rate and/or be entitled to take more deductions. Talk to your CPA to figure out the best entity structure for you to purchase a property.

The banks will also look at the individuals within the entity. They consider the net worth, liquidity, and experience of the members of the LLC.

Within the LLC, one of the signatories on the loan must have a net worth of at least the value of the loan.

The LLC member(s) need to have liquidity generally representing at least 20% of the loan.

The LLC member(s) must also evidence experience with running that type of business. A bank is unlikely to give you a loan to run a 100-unit apartment building if you’ve only ever owned a couple of single-family rentals. If you have a team member that has successfully run a 60-unit apartment building, the bank will consider the experience of your team member. You may also be able to overcome any experience deficit by partnering with an experienced and well-regarded property manager in the market where you’re purchasing the property.

The benefit of this type of arrangement is that you personally don’t have to have all of these factors. You can partner with those who do.

For example, we syndicated a 77-unit apartment building we purchased for $3,075,000. We did not have that net worth. We did not have 20% ($615,000) sitting in the bank, and we had never owned/managed an apartment building before. Fortunately, we were able to partner with others who met these requirements. We found someone with the financial requirements we needed. We added her to the loan as a principal guarantor or “key principal.” She’s not managing the asset, but she has her name on the loan.

Why would she want to do that? It’s given her experience on the loan. The next time if she wants to get her own loan, she has previous experience and can probably access a non-recourse loan because of it.

Then we partnered with our partner Chris, a great guy who had successfully raised $5,000,000 for the syndication of a 122-unit building in Dallas and was managing that property. We found the deal, so he was happy to join forces and bring his experience to it.

2. Whose Income Matters?

For a residential loan, the bank looks at the personal gross income of the borrower vs. the amount of debt they owe.

As a rule of thumb, your total debt should be no more than 45% of your gross income and your mortgage payment should be no more than 28%.

For a commercial loan, the income of the property itself is what matters most. The bank will look at the net operating income (NOI) of the property.

The DSCR is the ratio of the net operating income to the proposed mortgage debt service on an annual basis. It has to do with the available cash after debt payments are made.

Banks look at this because they want you to be successful in your real estate business! If you don’t make enough income to pay off the debts and make a profit, you won’t be successful and they’ll have to foreclose upon you. No one wants that! Banks want to hold money, not physical property.

So most lenders want a minimum DSCR of 1.20x.

To calculate the DSCR simply divide the NOI by the annual debt.

In our commercial loan example from above, the DSCR was 31,250 / 20,136 = 1.55. Most lenders would be happy with that.

3. What’s the Mortgage Term?

This is variable, but in general residential loans are for much longer terms. A typical residential mortgage length term is for 30 years. A typical commercial mortgage term is 10 years.

4. Are there Pre-payment Penalties?

Residential loans can almost always be paid off at any time, regardless of the payout term lengths, without any penalty. Furthermore, residential borrowers often choose to refinance when interest rates drop, which is much harder to do when a loan has prepayment penalties.

Commercial real estate loans typically do have prepayment penalties. Often the commercial loan prepayment penalty is on a sliding scale, growing smaller as a percentage of the loan each year.

For example, on one of our commercial loans, the prepayment penalty on years one to three is 3%, on year 4, it’s 2%, on years five to 10, it’s 1%. On a $5 million-dollar loan, this percentage amount makes a big difference. Each percentage point represents an extra $50,000 in penalty.

While commercial loans are shorter in term, they are less flexible during the term of the loan than are residential loans. If you have this kind of loan, you will have to refinance the loan at the end of its term, sell the property, or pay the amount in full. Also, depending on the loan, you may have to pay a prepayment penalty if you refinance early.