Most investors who purchase and fix up residential property become very familiar with acquiring a residential loan. Getting a loan for a commercial property is similar in some ways but different in others. Residential and commercial real estate mortgages have four key differences.
A borrower gets a pre-approval with residential mortgages to see how much home they can afford. On commercial mortgages, the buyer is already under contract before they apply for a loan with the lender. If the commercial property buyer wants to be pre-approved, they get a term sheet instead. A term sheet should be cautiously used as it can overstate the financing a buyer qualifies for.
A residential loan is paid off at the end of the loan’s term. This is not the case with a commercial real estate loan. A commercial buyer will have a loan term like a residential mortgage, but the loan will be due in less time than the term. For example, if the term is 30 years and the loan is due in 10 years, the buyer will owe the bank the amount they still owe for the loan in 10 years. The borrower is paying the 30-year rate instead of a 10-year rate.
Paying a loan off early may seem like good financial planning, but not in the case of loans for a commercial property. Commercial real estate loans do not allow for paying off the loan early without a penalty. The loan agreement will require the borrower to pay a certain percentage in addition to the loan amount if a business wants to pay off the balance earlier than the loan term.
If things go south with a loan and the loan defaults due to missed payments, the loan agreement may have a recourse action. Sometimes, the borrower will be personally liable for the loan if it cannot be paid. If the lender seizes the property but the loan still has a leftover amount, the lender will recuperate the cost. The bank will determine if the excess amount needs to go through a full or limited recourse or if the loan’s collateral will cover the amount due to the lender.
Residential mortgages come with stricter underwriting practices which helps protect the bank and the borrower. Over time, the borrower would gain equity in the home. Commercial buyers may not have any property equity and may be liable for any defaults on the loan.