First off let me start by saying that there are important and fundamental differences between Commercial Real Estate Financing and Residential Real Estate Financing. And whether you are new to Commercial Real Estate Financing or you are a veteran, it's important to review the information on this that follows on our blog. This will save you a lot of time, not to mention a lot of money.
Who's The "Real" Star In Commercial Real Estate Financing?
One important distinction between Commercial Real Estate Financing and Residential Real Estate Financing is, with Commercial Real Estate Financing the Property is the star, not the Borrower. What I mean by that is, with Commercial Real Estate Financing, the property must have a positive "cash flow" in order to qualify for the financing.
There is no "cash flow" aspect with Residential Real Estate. So, with Residential Real Estate the Lender is more focus on the borrowers ability to qualify. Don't take this to mean the Borrower does not have to qualify for Commercial Real Estate Financing, because he/she does. But the Lenders main focus is definitely more on the "Property" than the "Borrower".
Who Gets A Better Interest Rate, Commercial "Investment Property" Owners Or Commercial "Owner Occupied" Property Owners?
Another interesting distinction between Commercial Real Estate Financing and Residential Real Estate Financing is how "Investment Properties" are looked at when it comes to qualifying for your interest rate. On the Residential side of the equation an Investment Property is considered more risky as it relates to interest rates.
However, it is just the opposite in Commercial Real Estate Financing. And when you think about it, it makes perfect sense. If I am a Commercial Real Estate Investor, and I own say an apartment building, I will have many tenants paying me rent each month. If one of those tenants takes off in the middle of the month I still have all of the other tenants left to pay me rent.
Hopefully I collect more each month from my tenants than what my mortgage payment is, right? Otherwise I would have never gotten the loan to begin with.
That one tenant leaving is not going to cause me too much financial hardship. While I look for a new tenant I should be able to pay my mortgage without any problem. It's true I won't be putting as much in my pocket until I find another tenant, but I'm still paying my mortgage.
The Lenders understand that this happens with Commercial Investment Properties. And they feel much safer knowing the risk is spread out more evenly with more tenants.
Now let's take a look at the flip side. Let's say I am a business owner and I own my building where my business is. In the Lender's sees I am an "Owner Occupied" Commercial Property Owner. Now lets say my business starts to slide and all of a sudden I can't pay my mortgage.
I'm all alone here. I'm basically out on an island all by myself. There's nobody else to pick up the slack for me. This Owner Occupied scenario is more dangerous for the Lender.
There is more risk that if something were to happen to me I would not have anyone else to help me pay the mortgage. This is exactly why I will pay a higher interest rate being an Owner Occupied Commercial Real Estate owner.
So now you know why you will almost always get a better interest rate for an Investment Property.
Now Here's An Interesting Twist To This Logic
Lenders will allow for a higher Loan-To-Value Ratio for Owner Occupied Commercial Properties then they will for Commercial Investment Properties. Because an Owner Occupied Commercial Property owner has more to lose, Lenders will allow for a higher (LTV) Loan To Value ratio on these properties.
Another difference is Interest Rates on Commercial Real Estate Financing do NOT matter! You probably disagree with that statement, but if you will indulge me for a minute I'll explain what I mean.
Here's Why Interest Rates Don't Matter With Commercial Real Estate Financing
I mentioned at the start that interest rates for Commercial Real Estate Financing do not matter. Of course they matter, but not as much as you think they do, and not as much as they do in Residential Real Estate Financing. A bold statement to make, I know.
But an important, fundamental difference between Commercial Real Estate Financing and Residential Real Estate Financing is that with Commercial Real Estate we are more focused on the Return On Investment. Of course we want our homes to go up in value, but that's not what I am talking about here.
More often than not we buy Commercial Real Estate because it is an "investment". Even if it is just to house our business, it's still done more as an investment. Obviously when we buy a Multi-Family or Apartment property, it is done purely as an investment.
And this topic is also why it is crucial that you obtain your Commercial Real Estate Financing from an Expert. And more often than not, that Expert will NOT be your local Bank.
Here's an example that will explain both of my points.
In this example you are buying a Commercial Property with a purchase price of $1,000,000. You are going to put 20% down, or $200,000, and you will finance the balance of $800,000.
You can work with your local Bank, who will finance your property at 5.5%. Or, you can work with me, and I will be able to get you financing at 6%.
So, Who Will It Be? Your Local Bank at 5.50% Or Me at 6.00%? What's The Better Deal?
Is your decision easy? Do you have all of the information you need to make your decision? I have a feeling you wouldn't fall for the "lower the rate the better the deal" line, right?
Of course not! Because you know that with Commercial Real Estate it's ALL about the cash flow, right?
And my financing will provide better cash flow for you then the local Banks deal. Confused? It's okay of you are. Unfortunately most people assume that the lower interest rate deal is the better deal.
But it's not. Remember, you're not financing your house.
Let me help clear up any confusion. With most Commercial Loans the local Bank will offer you a good rate, which in this case was 5.50%. But the Bank's loan is amortized for 20 years. Typically most Banks will not offer you 30 year amortization on your loan. But our Lenders will.
And those 10 years will make a huge impact on your cash flow.
As they say on ESPN, "Let's Look Inside The Numbers".
The Loan:
$1,000,000 - Purchase Price
$200,000 - Down Payment
__________
$800,000 - Amount to finance
The Bank: $800,000 @ 5.50% amortized for 20 years = $5,503.10 per month (Principal & Interest)
Our Lender: $800,000 @ 6.00% for 30 years = $4,796.40 per month (Principal & Interest)
The monthly difference with my financing is $706.70 POSITIVE cash flow.
That means in just one year with my Lender you will put an additional $8,480.38 in your pocket! And, in just 5 short years that's an extra $42,401.91 in YOUR pocket!
So, would you rather have a lower interest rate, or more money in your pocket?
I understand how on the surface it would seem like a lower interest rate is always the best way to go. But, with Commercial Real Estate Financing, you have to look at the BIG picture. And the cash flow is more important then the interest rate. And more importantly, you should look carefully at who you decide to work with on financing your Commercial Real Estate.
If someone quotes you an interest rate, and they haven't asked to see documentation such as the last 2 years plus year to date Operating Expenses for the Property, Rent Roll on a Multi-Family, a Personal Financial Statement and looked at your credit, RUN as fast as you can!
Look, there are just too many variables with a Commercial Deal to have someone just quote you a rate. That's why we will never quote someone an interest rate. We can only do that after we have all of the facts about that particular deal. And besides, now you know why rates are not what you should be focused on anyway.
Here's something fun you can do with this information. If you're playing golf or hanging out with your friends and one of them mentions how he/she got a great interest rate on their Commercial Financing, now you can brag about getting more cash flow with yours!
Here's Another BIG Difference between Commercial Financing & Residential Financing.
Back in the good old days of Residential Real Estate Financing, when your loan package was submitted to the Lender everything was done by hand by an everyone involved, from Loan Officer to Underwriter.
Things changed over the years, in most part due to technology. There was a need for speed, and technology was the answer.
Today, on the Residential Financing side of things, automation rules. With technology like "Desktop Underwriting", it's typical for us to have an Underwriting decision in a matter of minutes, all without needing a real live, breathing Underwriter.
But not so with Commercial Real Estate Finding.
On the Commercial Financing side, there is no such thing as "Desktop Underwriting". And technology does not play a big role in the Underwriting process.
In fact, a real life, breathing Underwriter will make the decision on your Commercial Mortgage.
This makes a huge difference. And more importantly, how you approach your Commercial Mortgage must be completely different than how you would approach obtaining Residential Financing.
And This Brings Us To Another Difference Worth Discussing.
It is crucial for you to make the right decision on "who" you choose to work with. You cannot afford to put your Commercial Financing in the hands of someone who is not a true Commercial Financing Expert.
This is not the time to call the person who helped you with your last refinance on your home.
Let me clarify something. We are not suggesting that someone who does Residential Real Estate Financing is not capable of assisting you with your Commercial Real Estate Financing needs. That's not at all what I am saying.
What I am saying is, you need to know "what" they are. Are they a Residential Mortgage Broker who will occasionally do a Commercial Loan because it lands in his/her lap?
Or, are they a Commercial Mortgage Broker, who does Residential Loans because his Commercial Mortgage Client also needs assistance with his Residential Financing. And, since he/she probably started in Residential Real Estate Financing, they still have a good grasp of what they're doing. But, first and foremost, they are a Commercial Real Estate Financing Expert.
For example, I started in the business as a Residential Mortgage Broker. I reached a certain level of success in that niche. However, I found myself working more and more with Business Owners and Entrepreneurs.
And the more I worked with Business Owners and Entrepreneurs, the more I started handling their Commercial Financing.
And today, most of the work I do for my Clients is Commercial Real Estate Financing. I continue to do Residential Financing too, but it's just not the core focus of our Mortgage Practice here at AHG.
It's vital for you to know who you are working with. The differences between how a Commercial Mortgage is structured vs. a Residential Mortgage, are enormous.
Yes, The Structure Of A Commercial Loan Is Another Difference We Need To Discuss.
One of the main components that was used to qualify you for your Residential Mortgage was the "Loan-To-Value" ratio. In other words, how much would the Bank loan you vs. what your home was worth.
You may recall the sub-prime mess was in large part due to people borrowing 100% of the value of the home, then the home decreased in value, causing them to be upside down on their mortgage. Then when their adjustable payments ballooned so high and they couldn't afford to make the payment, they were unable to sell because the house was worth less than the balance of their mortgage.
Loan-To-Value.
So, in Commercial Real Estate Financing, Banks and Lenders look at something else to qualify your property. Remember, in Commercial Real Estate Financing the Banks/Lenders are looking at the property's cash flow.
In order to determine the property' s cash flow, they use a qualifier known as DSCR, or "Debt Service Coverage Ratio".
So, how do you determine DSCR? It's easier than you think, and I will keep it very simple.
Simply divide your ANNUAL net income (for the property) by your ANNUAL installment debt. For example, let's say you have a small Apartment Complex and your annual income is $150,000. And your annual installment debt (mortgage) is $100,000. You divide $150,000 by $100,000 and you get 1.5.
So, your Debt Service Coverage Ratio is 1.5. As a general rule, you are looking for a DSCR of 1.2 or higher. There are exceptions to this rule, but this rule will at least give you a good place to start.
The higher the DSCR, the more money the property is making.
If you are purchasing a Commercial Property, you will want to know what the current DSCR is BEFORE you start putting any money down and risking your deposit. This is why it's crucial you work with a Commercial Financing Expert BEFORE you go out looking for property.
Here's A Breakdown Of The Differences:
Commercial Residential
Property' s Income Borrowers Income
Borrowers Assets Could be no assets
Credit Worthiness Credit Score
Lend Own Money Sell to Fannie/Freddie
Business Decision Emotional Decision
Return On Investment Interest Rates
45 - 60 Days To Close Can close in as
little as 24 hours
Let's take a closer look at some of these differences. Remember, Commercial Real Estate Financing is a business decision, which is based on the return on investment for the property.
That's why the Property' s Income is most important, not the Borrowers income.
The Borrowers credit scores are looked at more closely with Residential Financing. In Commercial Financing it is the Credit Worthiness that's most important. With Commercial Real Estate Financing, they will look at the bigger picture, which is why the overall credit worthiness is looked at more than just the scores.
Another important consideration is with Commercial Real Estate Financing, the Bank or Lender will lend their own money. With Residential Financing, the Banks bundle their mortgages and sell them to Fannie Mae/Freddie Mac. That allows the Bank to continue to lend more money. And, the process continues.
Because Commercial Lenders lend their own money, they may use up their allotted funds in any given month and then cut off further lending. This is why it's so important to make a decision and move forward. I have seen people suffer from "shop till you drop" syndrome, and in the process the Lender gets annoyed and cuts them off so they can move on and loan the rest of their monthly allotment.
Some Final Thoughts On The Differences
We have been conditioned to buy "emotionally". It doesn't matter what it is. Could be a new car, a new home or a new Commercial Property. It's important to remember that when you look to buy Commercial Real Estate, it's strictly a business decision.
Do yourself a BIG favor and approach it like a business decision. Do not waste too much time "shopping" for your loan. As I mentioned above, if a Lender makes a good offer to you and you waste time shopping it, you will lose that deal. Besides, rates are never locked on a Commercial Mortgage until you close.
Yes, Lenders will give you an honest idea of what your rate will be, but a lot can happen between the time they offer you the rate and the time you close.
Also, if you start calling Banks asking for their rate, and there is not a significant exchange of information on your part to that Bank, they cannot honestly quote you a rate. You really need to get this. In a Residential situation a Bank/Lender can run your credit and look at their "rate sheet" and give you a good idea of what rate you are looking at.
In Commercial that just doesn't happen. There are too many variables.
For example, you can get a better rate on a property that cash flows better than on a property that is not cash flowing as well. You're the same borrower, so why can't you get the same interest rate? Because, this is NOT Residential Real Estate, where more emphasis is placed on the Borrower.
And, if you do not have the financials from the property, how will the Bank/Lender know what the cash flow for the property is? They won't. So how can they determine an interest rate? They can't.
The point is, if a Commercial Banker/Broker quotes you a rate without having ALL of the property' s financials and determining the property' s cash flow, RUN! Don't walk away, RUN away!
And better yet, don't ask a Commercial Banker/Broker for a rate unless you have first provided them all of the financial documentation they need to properly qualify your deal. Because now that you know better, it will be your fault when they give you a rate that doesn't exist.
Sorry, got to give you a little tough love here. This is just too important to get wrong.
Besides, asking "What's your rate" on a Commercial Mortgage can mean so many different things. What type of property is it? What's the cash flow of the property? What terms are you looking for?
And do you think if Trump and i are looking at the same property we are going to get the same interest rate? Of course not.
If it's a cash out refinance deal, the amount of the cash out can impact the rate (usually not in a stated loan).
And again, rates are not set until closing documents are drawn. Do you see why asking what the rate is does not make any sense? If anything, it signals the experienced Commercial Broker that you are inexperienced in Commercial Real Estate.
Don't worry. I will make sure you always look great!
This page was not meant to cover all of the differences in Commercial Real Estate Financing. But I hope I was able to provide you with some additional insight.
I guess the only thing left to do now is for you to pick up the phone and call me.
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