Commercial mortgages have very little to do with residential mortgages. They are two sides of the same coin. Although, commercial buildings are everywhere, in our cities, in our towns, and just about on every street block. The mortgage industry has a separate and distinct language between commercial mortgages and residential mortgages.
Whether you are a real estate investor looking for your first commercial investment or a residential mortgage loan officer seeking to step into the commercial mortgage atmosphere, there are many things you will need to forget, e.g. HELOC, discount points, good-faith estimates, etc., which all are not part of the commercial mortgage industry. Instead, you will need to learn about balance sheets, operating statements of property, profit and loss statements, current rent roll, business financial statements, among other financial jargon.
In this article we will cover the following topics:
|What is a Commercial Mortgage?|
|How does a Commercial Morgage Work?|
|What is the Difference Between a Commercial and Residential Mortgage?|
|How Many Years is a Commercial Mortgage?|
What is a Commercial Mortgage?
A commercial mortgage may be defined as any property that is not classified as residential, and maybe an income-producing property. Residentially, residential property is anything that has less than four dwellings (single-family, multi-family, duplexes, triplexes, and fourplexes). Commercially, it is any property that is not defined under residential, e.g. office buildings, retail stores, hotels, medical centers, land, apartments, etc.
A mortgage is a loan that is secured by real estate property as collateral. The word mortgage comes from two words, “gage” meaning commitment where we get our word to engage from, while “mort” meaning death where we get words like a mortician. Together the term “mortgage” means “death commitment.” For many, it does have a severe consequence and lifetime commitment “unto death” before the mortgage is ever paid off.
When people think of a mortgage, they may think that the term mortgage is synonymous with the term loan. In one sense, the term mortgage and loan are the same. However, technically speaking the two terms are not the same. The term loan deals with “borrowed money.” And the term mortgage deals with a legal document or mortgage instrument, signed by the mortgagor (borrower) who pledges their title to the real estate property as security to the loan. This legally allows the right for the mortgagee (lender) to take the real estate property if the loan ever goes into default.
When you analyze the word “commercial” in a dictionary you will find that there are many definitions of the word. Yet, with all the different types of definitions of the term “commercial,” you will notice that none of the definitions correlate with real estate. “Commercial” comes from the root word which means “commerce,” which has to do with business or trade.
How should we define “commercial” when we connect it with real estate or a mortgage? Fannie Mae’s definition of the residential property consists of real estate that has dwellings of four or fewer units. In other words, Fannie Mae defines residential property as a single-family dwelling, a multi-family dwelling of two to four units (duplex, triplex, and fourplex). Therefore, the term “commercial” in association with real estate concludes that “commercial” is anything that is “not residential” as defined by Fannie Mae. For instance, an apartment complex would be defined as “not residential” according to Fannie Mae, although, there are residential dwellings.
What is commercial real estate? As long as we stand clear of Fannie Mae’s definition of residential property, commercial real estate can be anything else. That is, commercial real estate may be anything that has commercial intent, shopping centers, apartments, a parcel of land, etc. The list can be vast and complex.
The residential market is regulated mostly by Fannie Mae, the commercial side is not. There’s no standardization and not all commercial brokers like the same type of commercial property. Unlike residential property, we can literally find a dozen brokers that want to lend to you with not much difference in the terms. However, with a commercial brokerage, the negotiation and terms are complex and will determine the type of property.
In addition, the real estate investor must understand the ends and out of the commercial property they are trying to mortgage. Lenders have their types of commercial property they like to lend to, some lenders may only like apartments, some only shopping malls, etc. The point is that you as the real estate investor must understand the description of the property, e.g. age, quality, size, condition, type, etc. This may appear to be simple, however, there are many variations to certain types of commercial real estate, e.g. shopping mall with an anchored grocery store vs. a shopping mall without an anchored grocery store.
How Does a Commercial Mortgage Work?
The underwriting process for a commercial mortgage application has more information than a typical residential mortgage application. For a residential mortgage application that residential loan evaluation is primarily based on the applicant’s personal income and market appraisal of the home. With a commercial mortgage, the process involves analyzations of the business or the income-producing ability of the property, it also conducts further investigation of the types of commercial property being mortgaged.
The analysis of the application for a commercial mortgage may include extensive interviews with those who are involved with the operations of the business, who may require resumes and background information of their experience and expertise of the operation.
In addition, the underwriting process will require intensive inspection of the property itself, e.g. rent rolls, tenant lease agreements, the creditworthiness of the tenants, etc.
What is the Difference Between a Commercial and Residential Mortgage?
Generally speaking, mortgages are divided into residential and commercial. The difference between a commercial and residential mortgage is basically in how the loan repayment is conducted. Residential loans are set up to be repaid by the borrower from their personal income or personal source. Whereas, a commercial mortgage is a business loan in which the repayment is structured to be repaid from the income that is generated from the commercial property.
Here are a few other differences between a commercial and residential mortgage.
Residential real estate generates no income, whereas, commercial real estate generates income through the property. Therefore, the commercial mortgage secures its debt through the income source of the commercial property and the residential mortgage secures its debt through the property owner.
Commercial borrowers typically have a higher financial background and generally staffed by businesses to conduct the application. The residential borrower only applies for a mortgage on a rare occasion (typically once every 5-10 years).
Residential mortgages are more widespread, smaller, and the market is full of mortgage brokers selling residential loans. Commercial mortgages are few and much larger. In other words, commercial mortgages are a smaller niche than their counterpart of residential mortgages.
The market alongside the government has catered to the residential market, implementing an environment where residential loans are pushed. On the other hand, a commercial mortgage is much more negotiable and fine-tuned, rather, much more competitive.
Obviously, the person involved in obtaining a commercial mortgage is important, but certainly not as important in a residential mortgage. With a commercial mortgage, depending on the size of the loan, these loans may not have any personal liability attached to them. The commercial property that is being acquired provides the collateral and the source of income for that property as a liability. However, many local banks and community banks still require a personal guarantee on smaller commercial real estate.
In addition, there are important risks that must be addressed during the application process of a commercial mortgage. Since there is not a standardized form for a commercial application, each commercial lender has its own specific requirements. Usually, this depends on the type of class of property.
Here are some of the more common risks.
Risk management: This includes identifying the sources of ricks; it is the evaluation of those financial risks together; measuring and the impact of those risks; and implement procedures to mitigate and control those risks (e.g. hazard insurance, building security, liability insurance, etc.).
Liquidity risk: This may have to do with the ability to liquidate the asset during a recession or if the market area tanks. However, it also includes if the property owners have enough working capital or cash flow to satisfy expenses, e.g. lenders, ongoing expenses, and building maintenance. Liquidity risk also deals with the potential relocation of the tenants once their lease is up.
Financial risk: This deals with the use of debt or the leverage of debt, which increases business risk.
Business risk: This is a type of risk that deals with economic conditions or economic activity, e.g. changes in interest rate.
Management risk: This type of risk has to do with how commercial property is managed. Or if it is a development project; the delays, tenant dissatisfaction, debt contract issues, even investor relationships.
How Many Years is a
Commercial mortgages are negotiable and can range from five to twenty-five years. There are many factors that will be depending on these terms. Lenders will investigate the size of the down payment you apply toward the loan; the more money you play the more negotiable leverage you may have later. Your credit score is another factor, both your business and personal credit scores will be typically be analyzed. Another factor is the repayment structure, this could be a balloon payment or a shorter amortization schedule. One more factor when commercial lenders consider the length of a commercial mortgage is business credentials. Lenders want to know how long the business has been in business.
Final Thoughts on What is a Commercial Mortgage?
What is a commercial mortgage? In short, it is anything that is not classified as residential property. It has very little to do with residential mortgages and is much more complex than your typical residential mortgage. A commercial mortgage most likely will be a real estate property that generates income. The underwriting process of a commercial mortgage is much more thorough and intensive. And there are risk factors that underwriters look into when considering a commercial mortgage application.
Geltner, D., Miller, N., Clayton, J., & Eichholtz, P. (2006). Commercial Real Estate Analysis & Investments. LEAP Publishing Services, Inc.
Reinhard, M. (2010). Commercial Mortgages 101. American Management Association.
Wiedemer, J., & Baker, K. (2013). Real Estate Finance. Cengage Learning.