If you are a property owner thinking about acquiring an apartment building, you’re not alone. As the country has shifted from ‘homeownership’ to ‘rentership’ coming out the Great Recession, the interest in and profitability of multifamily investment have increased. But what exactly is the difference between buying a house and buying an apartment community? Well, that opens up the question of what exactly is the difference between commercial and residential real estate?
The simple definition? Commercial real estate (CRE) generates income. Residential real estate is an owned residence. Now, things get murky, because some rental properties that produce income are financed by a ‘residential loan.’ Confused yet? Let’s break it down.
Are we talking rentals or multifamily?
In the lending space, rental properties with five units and up are financed by commercial loans, while rentals with five units and under can be financed by a residential loan. When you hear someone in the commercial loan industry refer to multifamily, they are referring to a property with more than five units. A residential real estate broker may call a two-family property ‘multifamily,’ and while they are technically right, it is somewhat of a misnomer that can lead to confusion. The difference comes down to how a loan is sized during underwriting.
Commercial loans are primarily sized and underwritten based on an asset’s projected net operating income (NOI). Residential loans are underwritten based on the creditworthiness and income history of the individual purchasing the property.
So with commercial loans, eligibility has a lot to do with property performance. Commercial lenders are typically looking to work with borrowers who can answer ‘yes’ to the following series of questions.
- Has the asset been at least 90% occupied for the past 90 days?
- Does the borrower have a net worth equal to or greater than the loan request?
- Does the borrower have at least nine months of principal & interest in cash on hand or marketable securities?
- Can you confirm the borrower does not have any history of bankruptcy, foreclosure, deed in lieu or is currently involved in a lawsuit?
Notice that none of the questions are asking about a borrower’s employment history or pay stubs. Yes, commercial borrowers are expected to have good credit, significant net worth and at least a partner experience in the asset class and market. But unlike a residential loan, employment history and pay stubs do not play a major role.
Prepayment Differences between Residential and Commercial Loans
First time commercial or multifamily borrowers also need to consider prepayment penalties, which are fees incurred for paying off a mortgage loan before it reaches maturation. These prepayment fees are not typical in the home mortgage world. If you take out a loan for your primary residence, and win the lottery the following year, you are going to typically be able to pay off the remaining balance of your home loan without incurring a fee. This is not the case with a commercial or multifamily loan. Why not?
Well, the lending institution has issued a loan collateralized by your commercial or multifamily asset expecting a set amount of interest revenue. If you are going to pay off your mortgage early, your lender is going to need to obtain that interest revenue through a fee to keep their balance sheet tidy or satisfy investors.
Remember, commercial Agency loans from Fannie Mae and Freddie Mac are often securitized (pooled and offered on the secondary markets) to retail and institutional investors relying on the interest income set forth in those loan terms. To recoup of that lost revenue due to an early loan payoff, loan terms usually include a declining prepayment penalty or yield maintenance fee structure.
Commercial Loans are Bigger than just Multifamily
While Hunt Real Estate Capital is best known for multifamily financing, our Proprietary Loan Programs (balance sheet bridge and fixed-rate products) can serve office, retail, industrial and hospitality investments as well.
So if you have a question about financing commercial real estate (which includes multifamily with five units or more), you should request a quote today. We’ll then connect you with an expert loan officer who has experience with your specific asset class and metropolitan statistical area (MSA).