You’ve heard the term “Knowledge is Power?”
If you are new to commercial mortgages, you’ll find that a little knowledge about the process (and how it varies from the residential mortgage process) will be very helpful for you to have a positive experience and to get your deals done smoothly.
You may be familiar with the residential mortgage process, so we’ll contrast the two types of mortgages here for easy reference.
Here are the 4 main areas where commercial mortgages differ from residential mortgages:
Let’s take a look at the differences.
The most basic and obvious difference between a residential and commercial mortgage is the property (land and structures) itself.
Residential properties are basically very similar in their use (as homes) and design. A 3-bedroom, 2-bath home may have a different outward appearance in New York than it does in California, but a house is a house. Its primary purpose and design is to be a living space for its occupant.
Commercial properties, on the other hand, can vary greatly in use and design. For example, property classified as “light industrial” could range from a cabinet-making shop to an automotive oil and lube business. And the design of structures even within a single classification such as “mixed-use” can be wildly different, especially for smaller properties. Popular multifamily structures share a common use, but you will see many designs and configurations.
How does property type affect the borrowing process? In a nutshell, it makes the process a little more complicated because establishing the property’s real value and business potential can involve more analysis and risk for lenders. Residential lending has benefited from the similarities of residential properties. The result is widespread standardization of residential appraisals and the methodology by which underwriters review appraisals. The same standardization doesn’t apply to commercial.
It should be understood that commercial real estate appraisals are different from residential real estate appraisals. In general, they are more complex and thus, typically more expensive and time consuming.
While both residential and commercial appraisals report property inspection results and comparisons with similar property listings and sale transactions in the market, the commercial appraisal will usually go into a deeper analysis.
Beyond the scope of a residential appraisal, the commercial analysis will measure the rental income of the subject property both in terms of the quantity and quality of the income source. Rent levels will be compared to similar properties in the market to determine that they are at or near market levels and thus sustainable. Like income, a property’s operating expenses are analyzed and compared to like kind properties in the market.
The income and expense analysis is used to determine a level of Net Operating Income (NOI) for the property. NOI is the amount of income after expenses derived for the benefit of the property owner prior to paying any mortgage debt associated with the property. NOI is then capitalized into value using a market derived cap rate or overall rate (OAR) which is based on the typical investor’s rate of return requirements considering the risk associated with certain property types in individual market areas. Essentially, NOI / OAR = Value.
In the end, the borrower / investor should be prepared for the increased expense and delivery time with the commercial appraisal as compared to a residential report. It can also be tempting for the borrower to order their own appraisal for use in trying to expedite the lending process. However, most lenders will not accept appraisals that are not performed by an appraiser with whom they have a history with and have thoroughly vetted for work quality. Additionally, a lender cannot close a loan transaction unless the appraisal is addressed to a lending institution as the client.
Underwriting is the analysis which determines if a lender will make the loan or not. Typically, commercial mortgages take longer for the underwriting process. This is especially true for many banks, where the lending decision may even go to a committee.
Conventional residential mortgage underwriting is primarily focused on the borrower’s willingness and ability to repay the loan. Usually this amounts to just verifying income and credit history, which can be done pretty quickly these days.
Traditional commercial underwriting goes into more detail and examines the property’s ability to repay the loan. This means the underwriters must review the financial information of the business being operated by the borrower (in the case of owner-occupied properties) and the stability/verifiability of the rents being paid to the borrower. They work to determine if the net income being generated by the property is sufficient to cover the expenses including principal and interest payments.
In underwriting a commercial real estate loan, the lender will rely on a metric known as Debt Service Coverage Ratio (DSCR). This metric is calculated using the derived property Net Operating Income (NOI is the amount of net income after expenses derived for the benefit of the property owner prior to paying any mortgage debt associated with the property) divided by the debt service expense (principal and interest payment). The target ratio varies by lender however, in the case with small balance lending, the ratio is usually expected to be a minimum of 1.20. This means that the property would be required to earn a net $1.20 for every $1.00 of debt payment based on principal and interest only.
What this means for you as a borrower is that you should expect the process to take a little longer than residential borrowing because the underwriting is more complex. And if you are applying for a full documentation loan, be prepared to provide documentation such as rent rolls and income statements. Having good documentation available for underwriters will minimize delays.
Environmental issues rarely come into play with residential properties, so this may be a new subject for first-time commercial mortgage seekers. But environmental issues do figure into commercial underwriting if such issues pose a risk to the business entity or have an impact on the value of the investment. To protect the cash flow of the property, environmental guidelines are set within the commercial underwriting process.
Certain types of properties – like automotive, light industrial, and warehouse buildings – face environmental concerns more often than others. But the truth is that many different types of commercial properties carry at least some environmental risk and require an assessment as part of a lender’s due diligence before financing a loan.
Not all commercial lenders treat environmental reports the same way. The more nimble non-traditional lenders are typically able to streamline the ordering of these reports and identify less expensive options for their borrowers. Certain costs and delays related to environmental concerns cannot be avoided, but any effort to mitigate these difficulties can make a real difference in the loan’s time to close.
Do you feel the power now that you have the knowledge of what to expect with the commercial mortgage borrowing process? Put your new knowledge to use to help make the process from application to closing go smoothly. Remember, commercial borrowing is a little more complex, costs a bit more for appraisals, and can take a little longer in the underwriting process than residential borrowing. BUT, commercial property investing can also be very rewarding — so if you’ve got your eye on a property, get started with the application process now.
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