Commercial Loans vs Residential Loans
December 02, 2018
The world of real estate finance consists of residential and commercial loans. In this article, we’ll consider the similarities and differences between the two. Assets America® makes commercial real estate loans starting at $10 million minimum. We can also provide you with all the services you need to handle your next loan high-end, commercial transaction, from simple to highly complex.
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Characteristics of Residential Loans
Individuals and families use residential loans to buy, build, renovate and refinance the residences of individuals and families. The typical residential loan finances single-family homes, condominiums apartments, cooperative apartments and townhouses. However, the residential loan market also includes multifamily homes with up to four units. Each unit must include a space to prepare food and to bathe. Lenders consider properties with greater than four units (5+) to be commercial real estate. Residential loans can take the form of a:
First Mortgage
Typically, this is a 30-year loan, but other terms are available. The first-mortgage lender holds the primary lien on the property. The lien allows the lender to foreclose and sell the house should the borrower default. You can secure a first mortgage if you meet the lender’s requirements for personal gross income, credit rating and indebtedness. Many lenders require your debt not exceed 45% of your gross income and your mortgage payments be no higher than 33%. The typical loan-to-value ratio of a residential property is 80%, meaning lenders prefer a 20% down payment. You might be able to obtain a loan using a smaller down payment, for example from FHA-guaranteed loans, but you’ll have to pay for mortgage insurance. No longer are there any prepayment penalties for residential mortgages (though many years ago there used to be).
Second Mortgage
If you have equity in your home, you can potentially borrow against it with a second mortgage. The lender holds a secondary lien on the property, meaning it’s entitled to a portion of the liquidation, if any, after the first lien holder receives reimbursement. Some folks use the proceeds from a second mortgage to pay down enough of their first mortgage to remove the mortgage insurance.
Home Equity Loan
This is the same as a second mortgage, except you can take out a home equity loan even after you paid off your first mortgage.
Home Equity Line of Credit
Known as a HELOC, this is a revolving credit line backed by the equity in your one to four-unit (1-4) residential property. In operation, it works like a credit card with a high credit limit and usually a substantially lower interest rate than a credit card.
Conforming Residential Loans
A conforming residential loan is one that adheres to the size limits required by the government-sponsored entities (GSEs) Freddie Mac and Fannie Mae. Most parts of the country limit the size of conforming single-family home mortgages to $424,100. Although high cost areas, such as many counties in California, have higher conforming loan limits up to $726,525. This size limit corresponds to the demands of the secondary mortgage market, because GSEs buy most residential mortgages and repackage them into mortgage obligations. Larger mortgages go by the labels “jumbo” or “super-jumbo,” and reach into the millions of dollars. Some high-cost locations have developed so-called “conforming jumbo” loans that are easier to repackage.
Residential Loan Rates and Terms
Many home mortgages operate through FHA loan guarantees. To qualify, you must have a minimum FICO score of 620. The minimum down payment is 3.50%, and there is a 1.75% upfront funding fee. Fixed interest rates start as low as 3.75% for a 30-year mortgage plus 0.85% for mortgage insurance known as PMI. There are no income limitations, co-signers are welcome, and you can typically get an 85% LTV on an FHA cash-out refinance. In a residential sale transaction, the seller can contribute up to 6% of closing costs. And buyers can have relatively high debt-to-income ratios, often over 50% loan to purchase (LTP). Non-FHA loans are also available, but the terms are less attractive.
Characteristics of Commercial Loans
The two main types of commercial loans are commercial real estate loans (CRE Loans) and commercial & industrial loans (C&I Loans). Assets America® makes both kinds of loans, starting at $10 million, with no upper limit. We offer commercial real estate loans for a wide variety of property types, including multifamily housing, offices, shopping centers, hospitals, hotels and many more.
A metric common to all CRE projects is capitalization rate (cap rate). Cap rate is a property’s net income divided by the purchase price. Naturally, borrowers and lenders prefer properties with higher cap rates, as they have the income cushion to help ensure timely repayment. Another important metric is debt service coverage ratio (DSCR), which compares net operating income to total debt service (i.e., payments of interest and principal). A DSCR of 1.00 means that the property can just barely support its financing. Most lenders want to see a DSCR of at least 1.25.
Commercial real estate loans require that borrowers have good credit, but the loan source determines the relative importance of the credit score. Banks pay close attention to credit history and score, whereas hard money (private money) lenders are primarily interested in the value of the property. If you have an above-average credit rating, you can obtain a bank loan at a good rate with a loan-to-value ratio of up to 80%. Private-money LTV ratios are typically in the 60% to 75% range.
Commercial Loan Rates and Terms
Commercial loan rates and terms depend on the loan type:
Construction Loans
These are short-term loans for the building and renovation of commercial properties. These loans are typically interest-only with terms of 12 to 18 months, although larger projects may require multi-year terms. The typical loan-to-cost ratio is 70% to 80% (though higher loan to cost (LTC) ratios are possible). Whereas you can expect a loan-to-cost ratio of about 75%. Other typical values for metrics are a DSCR of 1.25, a net-worth-to-loan-size of 1.00 or higher, and a profit ratio of at least 20%. As of the date of this writing, the best interest rates for construction loans are in the 4.75% to 6.00% range. The Federal Reserve has increase rates over the last 18 months.
Bridge Loans
These are short-term, asset-based loans that fund real estate transactions, including acquisition, construction, renovation and refinancing. They are easier than construction loans to access, albeit with higher interest rates, often up to 9.95% or more. Metrics for bridge loans include an LTC ratio around 80%, an LTV ratio in the 60% to 75% range, and a DSCR of 1.20. Bridge loans typically have no required minimum debt yield. Bridge loans are usually interest-only.
Mini-Perm Loans
These are temporary refinancing immediately following the completion of a construction project and the borrower’s receipt of a certificate of occupancy. The loan term for mini-perm loans is usually 18 to 30 months. Private money mini-perm loans have payments based on an amortization period of 20 to 25 years. They may also include a balloon payment due within seven years or less. Soft money mini-perm loans have longer terms and carry strong incentives for early payoff. Many mini-perm loans often include a period of one to two years of variable, interest-only payments. Look for an LTV ratio in the 75% to 80% range, a DSCR of 1.25.
Take-Out Loans
This is a permanent mortgage that replaces (takes out) a mini-perm loan once a property stabilizes and generates its expected income cash flows. Typical terms range from 5 to 30 years, and these loans have the lowest interest rates within the commercial real estate loan universe. Expect an LTV ratio around 75% and a DSCR requirement of about 1.25.
Mezzanine Loans
Additional financing through subordinated debt (and often equity as well) to increase the borrower’s leverage. Terms and rates are highly deal-dependent.
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