Real estate investment remains one of the most lucrative methods of making money and building your net worth. The stumbling block most prospective investors face, however, is financing.
While you don't need to have millions lying around to get into the real estate game thanks to financing, the ins and outs of this scares away a lot of beginners.
While the types of property one can choose to invest in via financing are varied, a commercial and a residential property loan are two very different beasts. Understanding the differences between the two is crucial if you want to make your investment a success.
Let's look at these differences in more detail.
What is Investment Real Estate?
Before getting into the specifics of each type of loan, let's clarify what sort of properties we're talking about when it comes to investment real estate. When speaking of residential properties, an investment property refers to a purchase that will generate income for you via rentals or a property you have purchased for tax purposes.
We're not talking about purchasing a second home here.
Commercial property is more varied with offices, retail spaces, industrial spaces such as warehouses and property that will be constructed by the developer via an SPV (Special Purpose Vehicle).
A key point to note is that a purchase of 4 or more residential units is classified as a commercial purchase and has to be financed by a commercial loan. Purchases of up to 3 units can be financed via a residential property loan.
We're not talking about purchasing a second home here.
The types of loans available are very different in both cases. The only common loan structure between the two areas is the traditional mortgage. However, even here, the terms of the loans differ quite a bit.
Which brings us to the first major difference between the two.
Difference #1: Loan Terms
Residential mortgages usually run from anywhere between 10 to 30 years. On the other hand CRE (Commercial Real Estate) loans run only up to 20 years. This, of course, makes it very important for you to have an exit strategy in place when investing.
The interest rates on a CRE loan are usually higher as well. Along with this, the LTV standards for both types of loans vary.
On a residential loan, an LTV of 80% on a traditional mortgage is considered quite good, with some lenders like the VA and FHA even offering 100% LTV, or no money down loans.
There are impossible for commercial investment properties and are available for only a small percentage of owner occupied commercial real estate loans, which of course, defeats the purpose of investing in the first place.
Difference #2: Your Application
The most important part of your application for a residential loan is your credit score. While some weight is given to your credibility and references if any, your credit score overrides everything else.
In the case of a CRE loan though, the net operating income generated from the property is of paramount importance. In addition to this, you need to present a full fledged business plan upon application.
When it come to evaluating your ability to make payments, in the former case, the size of your monthly income matters. It's important to state here that not all of your income will "qualify". Lenders will look for the longest and most stable sources of income.
What this means is, if you've quit your job within the past 6 months and now run a business which gives you double the income you earned at your previous job, your qualifying income from this source will probably be a big fat 0.
This is due to the fact that your business doesn't have a long enough track record.
In the case of CRE loans though, the rental income generated from the property forms the majority of the qualifying income consideration and describing how you plan on collecting and increasing this is given a lot of priority.
In addition to this, lenders like to see a steady payment history of rents from the property in question.
Difference #3: Metrics
When evaluating your financial fitness for a residential loan, the lender will most likely calculate this via two ratios: the front ratio and the back ratio.
The front ratio, also called the housing debt ratio is simply the total mortgage payment divided by all qualifying income on a monthly basis.
The back ratio, also called the total debt ratio, is the mortgage payment plus all other debt payments divided by the monthly income.
Just like some income qualifies and some doesn't, not all debt qualifies when calculating the back ratio. Typically, revolving debt such as credit cards are discounted while fixed debt, such as car payments are carried at full cost.
Lenders like to see a front ratio below 28% and a back ratio below 40% but this depends heavily on your credit score, with higher scoring applicants given a pass if they exceed limits.
Typically, revolving debt such as credit cards are discounted while fixed debt, such as car payments are carried at full cost.
In commercial cases, the only ratio that really matters is the debt coverage ratio, which is the income generated divided by the mortgage payment.
Lenders will always look for a value of 1.25 and above and your credit score doesn't have much of a say in the outcome. This doesn't mean it will be ignored. Just that it doesn't hold anywhere near as much weight in the case of a CRE loan.
Difference #4: Fees and Penalties
Commercial loans will attract a penalty upon prepayment, conveniently called a prepayment fee. This has to do with the fact that your commercial loans are usually packaged and then sold on further down the road to investors who purchase them anticipating a steady monthly income.
Their steady monthly income are your monthly interest payments.
Residential loans on the other hand don't attract prepayment penalties universally like their commercial counterparts usually do. Furthermore, residential loans usually have different types of penalties attached to them such as "soft" penalties and "hard" penalties.
Which penalty applies depends on the type of prepayment that has occurred and the duration of the loan term.
As you can see, commercial loans are a very different type of deal when compared to residential loans. While the purpose of the loans might be the same, to finance a real estate purchase, your approach to both will be completely different.
Commercial real estate requires you to have an exit strategy in place prior to applying for the loan. This is because your exit will determine the structure or type of commercial loan you apply for.
Despite the differences though, both loans offer investors great benefits when it comes to real estate investment. For all the talk of differences thus far, the one thing they both have in common is this:
Do your homework before opting for either one of them!