Real estate investing is all about leverage. That's the best way to grow and scale an investment portfolio. Whether it's with capital partner money, often referred to as other people's money (OPM), or bank financing, being able to purchase an income-producing asset for only a fraction of the value is a game changer.
Real estate investors involved in multifamily, office, retail, and other business investments will be familiar with commercial lending. This is the section of the mortgage industry that handles these types of assets. And there are critical distinctions between this sector and the residential lending side of real estate.
Here's an overview of commercial real estate lending, the pros and cons of different types of commercial loans, and whether real estate investors should try to get in on the action.
Commercial vs. residential lending
The biggest advantage to understanding commercial real estate lending is how much it differs from residential. Here are some of the ways.
A commercial real estate loan will typically kick in when you're dealing with a business such as retail, restaurant, office, etc. Further, commercial lending comes in on the residential real estate side typically when you have an asset that has five units or more. In this case, a duplex, triplex, or fourplex typically don't qualify for commercial lending.
Nowhere are the two lending products more different than in how they value the underlying asset. A residential loan will value the property based primarily on comparables; that is, what did a similar property in a similar neighborhood sell for? Comps give you the approximate value of your residential asset. On the commercial side, the asset is treated more like a business than a comparison to a similar property. Typical commercial lending valuations are made using the local capitalization rate (cap rate) as well as the net operating income (NOI) of the property.
For instance, if you have a 10-unit multifamily building with an NOI of $120,000 and a local cap rate of 6%, then your building valuation will be $2 million ($120,000 divided by 0.06). This approach is not used on the residential side.
Types of commercial loans
As with any bucket of lending products, commercial loans come in a number of different shapes and sizes. Here are the primary ones real estate investors should be familiar with.
Conventional commercial loans
Similar to the residential side, a conventional commercial real estate loan will have an amortization schedule of 20 to 30 years at a fixed interest rate. The loan-to-value (LTV) ratio for conventional commercial loans is 80%, with investors needing to put the other 20% as a down payment. This type of loan will not include working capital for any type of construction or rehab.
As the name suggests, a commercial construction loan can be obtained for the new build of a commercial property or multifamily building (five or more units). This is typically a shorter amortization, maybe one to two years depending on the time frame, and will be refinanced when the construction is complete using a conventional loan.
This type of commercial loan will require certain milestones to be obtained before more funding, called draws, is provided to the builder. Commercial construction loans also typically have higher interest rates.
Commercial loans can often have what is referred to as a balloon payment, whereas on the residential side this is rare. A balloon payment is typically where interest-only payments are made for a certain period, and a lump sum is due on a specific date. This differs from a typical residential loan, where loan repayments are a mix of interest and principal.
You'll see a lot more seller financing in commercial lending than in residential. Seller financing is typically seen when the seller of a commercial property "takes back" a portion of the down payment as a second mortgage. For instance, on the sale of an office building, the buyer may put down 10%, the seller 10%, and the bank finances the remaining 80%.
In this case, the seller would register a mortgage in second position to the 80% commercial real estate lender. The reason for more seller financing on the commercial side is because there's a smaller pool of buyers, and sellers are willing to get more creative to offload inventory.
At times in commercial lending, an owner will require capital for a short amount of time to "bridge" two different lending scenarios. For instance, between a construction loan and conventional loan, a bridge commercial loan may be needed from a commercial lender to help the owner better position, or stabilize, the asset. Bridge loans are typically for six to 24 months and carry a higher interest rate because qualification is easier -- and therefore riskier -- than a conventional mortgage application.