What are the main differences between a residential and commercial loan? Which is the best way to finance your multifamily property?
Most investors are familiar and find comfort when it comes to financing a single-family home, but become overwhelmed and intimidated when the conversation turns to financing a multifamily property. I would like to describe the differences between a residential and commercial loan, outline the different types of commercial lenders, and how to qualify for a commercial loan. A commercial loan is simply a loan that finances properties that are five or more units.
Key differences between a residential and commercial loan
– Commercial loans are underwritten using the income approach and rely heavily on the performance of the property that is being financed. Residential loans employ the sales approach, where the comparables (comps) in the market weigh heavily on valuing the asset.
– Commercial loans tend to have a much shorter maturity period than a residential loan. This shorter maturity requires a balloon payment at the end of the term. The maturity periods are typically five, seven or ten years.
– Commercial loans employ a Debt Service Coverage Ratio (DSCR) to analyze the viability of a loan. DSCR is simply a formula that measures a company’s ability to service its current debts by comparing its net operating income with its total debt. You take the Net Operating Income and divide the total debt service. The rule of thumb for a reasonable DSCR is 1.2.
– The interest rate on a commercial loan is usually higher than a residential loan.
We consider the financing portion of an investment to be a crucial part of our three-legged framework, which entails “Buy Right, Manage Right and Finance Right”. We employ the analogy of our framework to a wheelbarrow, where if one of the legs is weak or unstable, it will topple over. It is vital to master the financing portion of the investment, or else you will put the investment in jeopardy. The first thing an investor has to realize is that money is a commodity, thanks to the Internet.
Years ago, banks had more control over the process and made it more difficult to secure financing. But once a product is turned into a commodity, the consumer benefits with lower and more aggressive pricing. If you don’t like one bank’s terms, walk down the street and elicit a quote from another bank to use in the negotiating process.In commercial lending, Net Operating Income (NOI) is key.
Different types of commercial lenders
2. Life insurance companies
3. Conduit lenders
4. Mortgage banker
5. Mortgage broker
6. Agency lender
7. Private Money
Banks are the preferred lender of choice for most investors. You can break down banks into three different types: commercial bank, savings bank and credit union. We have funded most of our deals through a commercial bank. There are a few benefits to using a commercial bank.
– A local commercial bank is usually much easier to work with. They tend to have an intimate knowledge of the market and are in search of demand deposits.
– It is easier to get a deal financed with a commercial banker, especially a portfolio lender. Portfolio lenders hold their mortgages in their portfolio and do not sell them off to the secondary market. This allows them to be more flexible with their terms.
– Once you establish a relationship, the bank may even bring you deals from their portfolio.
There are a couple of drawbacks with using a local bank. The loans have a shorter amortization period, the prepayment penalties can be onerous, the interest rates may not be as competitive as other lenders and the loans are usually recourse (the borrower has to personally guarantee the loan). When you first begin your investing career, commercial banks are the easiest and quickest way to finance your deals.
A credit union is a financial institution that is owned and controlled by its members. It is not open to the public. All three of these banks rely on customer deposits to be able to lend money out for loans.
Life insurance companies
Life insurance companies are a huge source of real estate loans. They originate loans from all of the premiums they collect from insurance policies. Insurance companies are risk averse and tend to lend on around a 75% loan to value. They also seek out assets that are in newer locations. Mortgage brokers will employ insurance companies when looking to finance a deal.
A conduit lender is an investment bank that originates loans. A conduit loan is an individual mortgage that is pooled together with other commercial loans and then securitized. This process is known as commercial mortgage back securities (CMBS), where these loans are converted into fixed income securities.
A couple advantages of a conduit loan are that they are non-recourse loans, the amortization is longer than those of commercial banks, and rates are very competitive. On the other hand, these loans are expensive to originate and they have hug prepayment penalties. There is very little flexibility with these loans, although many of these loans are coming due on the next twelve months, which may force lenders to come to the table and renegotiate the terms.
Mortgage banker/Mortgage broker
The mortgage banker originates and funds commercial real estate loans for a fee and then sells the loans. They generate revenue by charging origination fees and servicing the loan. A mortgage broker, on the other hand, is an intermediary who works with the borrower and lender to secure financing. One distinct advantage of a mortgage broker is that they have access to hundreds of different types of loan programs to match the borrower with the program that suits his or her needs.
An agency lender is a commercial mortgage-banking firm that originates and underwrites loans for the purpose of selling back to either Fannie or Freddie, but not all agency lenders sell their loans back. Agency lenders have strict underwriting guidelines, and their terms are competitive in the market. They quote their interest rates in relation to the Ten-year treasury bond. We have seen rates priced at around 200-250 (100 basis points equal 1%) basis points above the Ten-year treasury. These loans are non-recourse and have longer amortizations.
Also referred to as hard money, this method of financing commercial real estate is not as popular. The fees on private money tend to be very expensive and the interest rates can hover anywhere from 8 to 25%, depending upon the experience of the investor and the quality of the deal. When seeking private money, a lender requires much more equity in the deal to protect his investment and will usually lend on 65-75% of the loan to value of a property.
Any investor who is looking for short-term money and can’t get conventional financing should consider utilizing private money. I have a student who uses private money to purchase the investment, repositions the investment (AKA increases the NOI) and goes to his local bank to refinance the property once it is stabilized. He uses the funds to pay off his private lender and utilizes the remaining funds for his next deal.
It depends on where you are in your investing journey. Beginning investors will find it easier to utilize local banks, while seasoned investors will find the benefits of agency financing attractive, even with all the effort involved in securing agency financing. If you have any questions financing your next deal or are looking for a partner, we’re here to help.
DISCLAIMER: This article expresses my own ideas and opinions. Any information I have shared are from sources that I believe to be reliable and accurate. I did not receive any financial compensation in writing this post, nor do I own any shares in any company I’ve mentioned. I encourage any reader to do their own diligent research first before making any investment decisions.
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