Commercial versus residential loans
So you’re considering the big move up to some form of commercial property investment. This could mean retail – a single store or small strip mall, for example, or office building or warehouse or light manufacturing building as well. It could also mean any residential multi-family housing that contains five units or more. Since commercial space is traditionally a much greater leap in pricing than single or small multi-family residential housing, how best do you finance the potential investment?
Most individuals don’t have the deep pockets required for such serious cash outlays relative to simple residential buildings. And I have advocated in previous articles here for the concept of partnerships as a way to pool investor money for larger and more lucrative investments. But at some point, if you’re going commercial, you’re going to require a commercial mortgage to handle the ability to make the deal happen. So where is the best place to look, and how are commercial loans evaluated?
Commercial lending departments
Most banks offer commercial loans, but they are traditionally processed in a separate department from residential lending within each bank. Rules tend to be more stringent than residential loans, and a common axiom is that interest rates associated with commercial mortgages will definitely be higher than for residential loans. In addition, while amortization times may compare favorably with residential loans, expect much shorter time limits on when the mortgage will come due, and so balloon payments should be expected within five to seven years on most commercial loans. Thus, you can expect your monthly payments to be comparable to residential loans due to longer amortization schedules, but you will have to prepare for that short term balloon pay-off of the loan.
Debt to income ratios
Another key difference that commercial loan evaluations require relative to residential lending, include a greater weight placed on debt to income ratios. For residential mortgages, one’s personal income is paramount in determining whether you may qualify for a loan. In commercial lending, the building’s ability to throw off cash flow through its net operating income is paramount. So all your income statement documentation (or pro formas if the building is new) must support this positive net cash flow. A lender will look at the building’s debt service coverage ratio (DSCR) as a key determinant. This ratio is a simple measure that looks at the projected net operating income, then divides it by the mortgage payment amount. Most DSCR’s need to come in at a minimum ratio of 1.2 as a general rule of thumb in commercial lending.
Loan to value ratios and credit scores
In addition, lenders will look at the loan to value ratio you’re applying for, and in most cases, 70% LTV would be the maximum ay bank will allow. Of course, the lower the LTV, the greater the likelihood of your obtaining the loan – simply because the bank’s risk is reduced when you have more equity at stake in the property. The lender will also look at your credit score to get a good idea of how you’ve handled credit through your lifetime. Obviously, the higher, the better. Minimum commercial credit scores need to be in the 720 range…but your chances for obtaining a commercial loan increase greatly as your approach the upper end, or 850.
Another key ingredient in a lender’s commercial loan department deciding on your loan approval, will be your previous landlord experience. General business experience (if you have already run a successful business) will also be taken into account in a very positive way too. You’ll want to show proof through examples and documentation of your past landlord/business experience. Showing that you’ve been successful in the past will be a boon to any attempt to obtain a commercial loan. It also helps to write up a separate business plan for your potential new investment building to help sway a lender’s commercial loan officer. The more professional and business-like you come off, the greater your likelihood that a lender’s loan officer will see that you’re treating this mortgage seriously, and that will afford you a greater opportunity and chance to be rewarded with the mortgage loan.
Hard money lenders as last resort
If all else fails, and you are unable to obtain a commercial loan from a bank, there of course, hard money lenders out there in droves. I have previously written several articles here on where to find them and how to apply with them. But – they are only to be used as a last resort. Their rates and terms tend to be ridiculously onerous – especially since they know they represent your last ditch attempt to make a commercial deal happen. Only utilize them if the deal still makes sense after being initially turned down by a bank.
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