I frequently run across individuals new to the commercial real estate space and their initial comparison is to residential real estate. When they start asking about terms, rates and fees it is clear the base line knowledge is residential. That would be expected, many individuals if they have not gone through with a residential transaction themselves, either know someone who has or at minimum know the basics of the 30 year mortgage or hear what current rates are in the news. Let’s break down some of the basic differences between the two.
Terms
Typically what you see in residential mortgages is the 30 year mortgage, if not the 30 year then a 20 or 15 year. Majority of the time, it will not vary to far beyond that. There are ARM’s but those are not nearly as popular as their fixed counterparts. Regardless of bank or lending institution those the terms will be fairly typical.
In commercial real estate, you frequently have terms with balloon payments and this will vary by institution. The most common is the 5/20, a 5 year term with an amortization of 20 years. The amortization of 20 years, provides a monthly payment, as if the mortgage was being paid off over a 20 year period. After that 5 year term, you can pay the mortgage off or what most people do is refinance into another 5/20. Residential lenders have fairly standard terms on mortgages, that will not always be the case with lenders on commercial real estate. Some banks prefer to offer a 25 or 30 amortization on a 5 year term. Other banks might want to offer a 15/15 term and amortization. Much of what terms offered will be based on a lenders credit risk appetite and business cash flow to support the mortgage.
Rates
Residential mortgage rates will vary from lender to lender and will be subject to risk factors but in many cases market forces will set the initial base line. External forces moving rates would be the bond market, inflation, other Fed monetary policy. Internal forces that could affect the rate and ones the borrower can control would be, debt to income ratio, credit score and loan to value.
Rates on commercial mortgages will traditionally be higher than residential mortgages. You will see a higher level of competition on rates as well. If a bank wants to win a deal they will be more flexible with the rate offered. In a similar manner there are external forces that will determine the rate on commercial mortgages. They could range from Fed rates, bond markets, lender risk appetite, commercial real estate market and property type. Internal forces impacting the rates, will be business cash flow, business debt, LTV, collateral and personal liquidity. The greater your ability to lower the risk profile on your loan the greater your opportunity to impact rates and terms.
LTV
Most residential mortgages will allow for a pretty low down payment and their are a variety of programs out there that can assist. You can easily have a 95% LTV mortgage on residential real estate and it would not unheard of. PMI also allows for a buyer to come in with a lower down payment.
In commercial real estate, there are opportunities to put less down, but 25% down is industry average. When putting less than 25% down, it will stem from either the borrower using an SBA loan, where you can go as low as 10% down, or the lender is comfortable going with less than the 25%. There is no PMI for commercial mortgages and so the down payment is likely to be a hard and fast starting point.
Fees
Fees on residential real estate can be nominal compared to the overall mortgage transaction. Between appraisal, title, inspections and any other closing fees, you can look at closing cost below $5,000. It should be noted that some of those fees are going to be contingent on the sale prices of the house and thereby the large the purchase or mortgage the higher the fees. Commercial fees will be much higher. A clear comparison are the appraisal fees. Residential appraisal will probably not be much higher than $500. Commercial appraisals are not likely be start less than $2,000. Very quickly you will see fees on commercial real estate start to move about that $5,000 mark.
Pre-Approvals
Pre-approvals are very common in residential real estate transactions, not nearly as common in commercial real estate. They are out there but you are more likely see “term sheets” as opposed to a pre-approval. A term sheet will indicate that the lender is open to the transaction and if it were to move ahead, what the terms of the deal would be.
There are so many factors that determine a commercial real estate deal, we did not even touch on investment real estate, environmental aspects and more. The key is to ensure you educate yourself before going into a commercial transaction. The nuances are many and the deals can very greatly by lender.
About David
David Coletta has 15 years in the banking industry and most recently has worked with businesses earning between $5-$50M a year in revenue. If you are looking to learn more about how David can assist you and your business please reach out via the contact section.