Want to Invest in Commercial Properties vs. Residential?

Due to the recent poor performance of real estate mortgages, banks and government regulatory agencies are reviewing, reassessing, and reinforcing commercial real estate (CRE) guidelines. This has been imperative at this time because the CRE fundamentals remain weak. Analysts need to review commercial real estate lending practices to determine the nature and extent of the bank's weaknesses and vulnerabilities

Want to Invest in Commercial Properties vs. Residential?

By Workers World Today Partners 

Investors looking to purchase real estate quickly learn that the market is divided into two distinct markets: commercial and residential. The residential market is composed of properties that are mainly primary or secondary residences and are generally not purchased for the purpose of generating income. Most residential properties are purchased because buyers fall in love with the property they will be calling home. Commercial properties are purchased based on financial calculations such as cap rate, cash flow, and cash-on-cash return, and revenues it will potentially earn for the owner. Emotion is not a criterion in the purchase of a commercial property.

The requirements for purchasing residential real estate are much less stringent than the requirements for purchasing commercial real estate. Residential real estate purchases are based on the buyer’s personal credit scores and their debt-to-income ratio (DTI). Lenders will lend to buyers if their DTI is below a certain percentage which is usually 45 percent or less. Buyers who have lower credit scores can still obtain financing if they have a larger down payment. Once the buyer meets the lender’s requirements s/he will qualify for financing and purchase the residential property.

The purchase of commercial property is a more complex transaction. Most commercial properties are purchased with non-recourse loans which means, if the buyer fails to make payments, the lender is not able to pursue the buyer personally in collection of the monies owed. For this reason credit scores and DTI are not criteria used in the purchase of commercial properties. Instead lending on commercial properties is based on the potential cash flow, cap rate, and net operating income (NOI) generated by the property.

Sales of residential properties can occur in as little as a few hours, but the average time to close is approximately a month. Commercial properties can easily take a few months to over a year to close. For this reason commercial real estate agents earn a higher commission on each sale as compared to the sale of residential properties. Commercial real estate agents may sell a tenth of the number of properties as compared to sales of a residential agent but can end up with an annual income more than twice the amount.

Lenders have no problem with lending to first-time investors for the purchase of a residential property as long as the lending requirements are met. Whereas first-time investors will have difficulty buying a commercial property as lenders are reticent to lend to someone with no experience. Generally commercial loans require one of the primary applicants to have experience dealing with the type of property being purchased. This requirement shuts the door on newer investors.

The potential profit from a commercial property sale is much greater than a sale on residential property. The old adage of higher risks potentially bringing higher rewards is the driving principle behind this reality. Most investors begin their careers investing in residential real estate and then move into commercial real estate after several years of successful investing.

Assessing Commercial Real Estate

Due to the recent poor performance of real estate mortgages, banks and government regulatory agencies are reviewing, reassessing, and reinforcing commercial real estate (CRE) guidelines. This has been imperative at this time because the CRE fundamentals remain weak. Analysts need to review commercial real estate lending practices to determine the nature and extent of the bank’s weaknesses and vulnerabilities

Commercial real estate conditions have been deteriorating nationwide, dipping low since 2003. Vacancy rates and office markets are waning fast due to the loss of office jobs, economic crisis, and poor recovery. Analysts say that all these could be traced to the 9/11 attacks. The said incident resulted in prolonged weakness in retail markets with less and less consumer spending. Resulting effects include prolonged losses in manufacturing, unemployment, and a low inventory-to-sales ratio.

A Commercial real estate agent acts as the anchor between the landlord and the tenants. He has to come up with a solution for both the landlord’s objective in profits and the tenant’s need to control cost. The agent’s knowledge and expertise in managing property aids in finding suitable alternatives in settling any issues of conflict.

The CRE agent can present a variety of lease options to be considered by both the landlord and the tenant:

“Modified Net Lease” in Commercial Real Estate: Under the “modified net lease” the tenant has the option to pay insurance and taxes rather than paying all expenses beyond rent. The tenant will negotiate sharing of maintenance expenses with the landlord.

“Triple Net Lease” in Commercial Real Estate: Under this lease industrial enterprises and multi-occupancy leaseholds must directly pay expenses essential to building maintenance in addition to the rent amount.

“Gross Lease” in Commercial Real Estate: In this kind of lease, the landlord shoulders all expenses related to the property s/he is leasing. Such expenses include but are not limited to taxes, property and fire insurance, and building maintenance.

Commercial Mortgage Loans for Small Investors: Commercial mortgages specialize in providing mortgage loans essential to small investors. Small investors can greatly benefit from investment loans that fuel their ventures and enable greater return in the end.

Property Types in Commercial Real Estate: Commercial real estate agents offer diverse expertise and can assist with transactions involving business edifices such as offices and commercial spaces, industrial sites and parks, as well as retail and wholesale establishments.

Real estate agents who are well-rounded in residential real estate are still hesitant to venture into areas of commercial real estate. They are aware that venturing into this arena requires more skills and knowledge than mere prospecting and appraising. So you have to be prepared for this step, but the benefits can be rewarding.

Commercial Real Estate Financing: The Rules Differ From Residential Financing

Commercial real estate financing is an area filled with confusing terms and math concepts that can be difficult to grasp. Regardless, there are intrinsic differences in commercial financing vs. residential financing. The main difference is that you will be required to demonstrate your property’s earning potential. You will need an appraisal from a reputable source which will show your financial lender a realistic view of your earning potential and prove that you are able to meet your obligations after all your other bills are paid. In addition to paying for an appraisal, you will need to consider other documentation needed for your lending institution:

  • Income and expense statements demonstrating solid income potential
  • Financial statements for all owners of the property and the borrowing entity
  • Profiles of your chosen management team
  • Plans, including any necessary construction blueprints, explaining the proposed  use of the property
  • Another important aspect of commercial real estate financing is that banks determine the value of your property somewhat differently. In residential real estate lending, everything depends on the value of your property at the time of the sale. With commercial lending, the value of the property will be based on the following:
  • Anticipated use of the property
  • Expected returns on investment for the property (i.e. its income-earning potential)
  • Geography (location)
  • Type and size of the property
  • Perceived risk to lender & market conditions

Even with the differences in financing requirements, investing in and offering commercial real estate can be a fantastic investment. Commercial tenants are significantly lower-maintenance than their residential counterparts. A business owner is going to call a plumber to fix his leaky faucet because it interferes with his business whereas a residential tenant is going to call you. The downside of this is that a commercial tenant is going to expect extremely fast turnaround when he does call you, because his or her livelihood depends on your prompt response. If you are able to keep your property in top shape initially and respond quickly to repair requests, you will discover that commercial real estate investment may be the right option for you.

Requirements for Commercial Real Estate Loans

Graduating from single-family and small multi-unit properties to larger properties? As your investing grows, so do your financing needs. Larger properties will not conform to the same loan guidelines as smaller properties. You may find yourself faced with obtaining a commercial real estate loan. Commercial loans cover financing for multi-unit properties over five units, mixed-use properties (like a storefront with apartments above) and any large retail, industrial, or development property.

You’ll want to shop around for the terms that are right for you. Most commercial loans are amortized at 20 or 25 years, rather than at rates of conventional residential mortgages, which are commonly amortized at 30 years.

In addition, many commercial lenders will only finance between 70 and 80 percent of the value of the property. In residential home mortgages, the loan to value (LTV) ratio can be anywhere from 80 to 100 percent, based on factors like credit, and owner occupancy.

The interest rates on commercial loans tend to be higher than those on residential property, so plan on paying more in interest on a commercial mortgage.

Commercial loan requirements do vary considerably among banks. The lender will carefully consider:

Incorporation — Some banks will require that your real estate company be established; one large chain requires incorporation for a minimum of two years before becoming eligible for loans. Other banks that are smaller or regional may be more flexible.  

Appraisal — The lender will want to know what the property is worth. Commercial properties are appraised differently than single-family residential real estate, as the rents have a direct correlation with the value of the property. For the commercial property, the lender will want to know what kind of income the property is bringing in, which also affects the value.

Financial Records — You may need to produce your past business tax returns and personal tax returns. One bank requires records of the previous two years in some cases, especially when loan requests exceed $100,000.

If you want to learn more about a commercial real estate loans, you should begin checking websites of various banks with whom you have previously dealt, or are in the region of your property or where you reside.  

Be aware of this list of general requirements, make your list of questions, and be prepared to discuss pertinent information about your finances and the property for which you are seeking a loan. Then visit or call a bank to speak to different representatives in person before you settle on the right lending institution for you.

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