The Differences Between Commercial and Residential Loans
September 18, 2023
Perhaps you’ve heard that commercial loan transactions are far more complex than the residential deals you close each month. Maybe you’ve heard horror stories that have kept you from diversifying your business with commercial loans in the past. While commercial lending is generally more complex than residential, the process for originators does not have to be as scary or time-consuming as you may have heard. In fact, small-balance commercial loans (generally those under $2 million) can behave like residential deals in a few key ways – especially when it comes to multifamily properties. Still, there are some important differences between residential and commercial lending to keep in mind as you look to add to your product offering:
1. The Properties:The appraisal process for a residential home is a relatively simple process. Since homes within a neighborhood generally share similar characteristics, lenders can look to nearby comps to get an understanding of the property’s value. On the other hand, every commercial property is unique. One block in a mid-sized town can include retail strip centers, apartment buildings, self-storage facilities, and offices. Each of these are commercial properties, yet none can be compared with one another during an appraisal. As a result of this additional level of complexity, commercial appraisals take significantly longer too complete and are more expensive than residential appraisals.
2. The Terms:The typical residential home loan is packaged as a 30-year mortgage that amortizes over the loan’s full term. One the other hand, commercial mortgage loans commonly include terms of 5 or 7 years, with an amortization schedule that lasts longer than the life of the loan. Commercial loans are generally viewed as more risky than residential loans. As a result, commercial loans can be more difficult to obtain than residential loans. In fact, the general challenges investors face when attempting to secure commercial mortgage loans with banks has led to the creation of a number of alternative lending sources. These solutions generally offer greater flexibility in exchange for a higher interest rate. Since the loan terms are shorter, commercial mortgage borrowers must refinance their loans more often than their residential counterparts, especially if they plan to keep their property for a long time. While having to secure a new loan every few years can present a challenge for borrowers, the shorter terms do allow for greater flexibility.
3. The Underwriting:Originators who start taking on commercial loans should keep this one underwriting reality in mind: Residential underwriters work to determine the borrower’s ability to repay the loan while commercial underwriters work to determine whether the property in question generates enough revenue for the borrower to repay the loan. This means that underwriters must not only review the borrower’s creditworthiness, but also their business’ performance and rental information as well. One prevalent metric within the commercial mortgage transaction process is the Debt Service Coverage Ratio (DSCR). This metric is calculated using the derived property Net Operating Income – the amount of net income after expenses – divided by the debt service (the principal and interest payments). The objective for the lender is to determine whether or not the prospective borrower’s property will generate sufficient income to cover the monthly loan payments. This underwriting process takes longer than that of residential loans.
Keeping these differences in perspective will help you gain a more complete understanding of commercial lending in general. In time, also you’ll discover similarities between commercial and residential loans.