Commercial Mortgage Basics: Understanding the Differences Between Commercial and Resential Loans

Many single family homeowners want to make the leap into commercial investing but have no idea where to start. Financing can be the most daunting part of this endeavor. While an apartment is very much like several tiny homes, a commercial mortgage is vastly different from owner occupied financing.

The Standard Commercial Mortgage: Debt Coverage Ratio

Commercial financing is based on the income of the property not the owner. Most of the time the underlying property will produce more than enough cash to cover the mortgage payments. Banks typically require the property to produce 1.1 to 1.25 x the monthly mortgage payment. For example, if the mortgage payment on the property is $1,000 per month, the property should be producing after all expense are paid at least $1,100 to $1,250. This math makes it much easier for borrower to qualify for commercial financing because credit scores are typically not an issue (unless they are abnormally low).

The Standard Commercial Mortgage: Loan to Value

Unlike most residential loans, commercial loans typically require the borrower to put 20% down. While it is possible to get away with 10% down, the interest rate on these loans is anywhere from 4% to 6% higher. This can often prove to be a large hurdle for would be investors. Several ways to get around this are equity partnerships and personal loans. Typically second loans are not done on commercial properties because of the risk in the deal. This is in contrast to many homeowners, who might get a second loan to avoid paying Private Mortgage Insurance.

Also, note that this article is discussing the “standard” commercial loan. While it is technically possible to get no money down loans, these financing vehicles are the exception. They typically come with a very high interest rate and require a personal guarantee. These financing vehicles should be reserved for people who are seasoned investors or who are pursuing a very aggressive rehab.

The Standard Commercial Mortgage: Loan Term

The typical loan term for commercial mortgages is a 10 year loan with a 30 year amortization period. Essentially, this is the same as a 30 year loan with a requirement that the loan balance of the loan be paid off in 10 years. The payments would be the same as a 30 year loan because of the amortization schedule, but the borrower would need to refinance or sell the property at the 10 year mark.

The Standard Commercial Mortgage: Prepayment Penalties

If you sell your personal residence, you can simply pay off the balance of the mortgage at that time. Commercial loans have deescalating prepayment penalties. The fee might be 5% of the loan the first year, 4% the second year, and so on, with no penalty after year five. This is important because it dictates how long your holding period for an investment will be because it is usually no a good idea to sell before prepayment period has ended.

Making the leap from a personal residence to commercial property can be scary and exciting. Having the facts before you apply for a loan can take some of the fear away.