Hopefuls in the residential real estate game are eyeing their next options carefully. Many residential mortgage originators are now looking to commercial real estate to diversify their business portfolios, but may not know exactly how to get into the commercial market. They don’t know what types of lending options are available, or even what makes a good deal in the first place.
It’s not enough to have residential mortgage experience if you’re wanting to try out the commercial real estate game. A recent Silver Hill Funding blog post suggests originators need to seek out educational opportunities and add more tools to their toolbox. Growing the pipeline from residential to commercial requires a diversification tactic. Specifically, understanding the differences between residential and commercial loans.
Understanding how property types themselves differ from residential to commercial is the first step. Commercial property is defined as real estate used for business activities. Many states qualify residential properties as commercial for tax purposes if they contain more than a specified number of units.
“Unlike residential homes, which can all look alike within a given neighborhood, the commercial properties located along a single city block may all appear unique and serve separate purposes,” writes Silver Hill.
Offices, warehouses, retail, and apartment properties have very little in common but are all considered to be commercial real estate. Start with your local market, and learn the property types that are more prevalent in one area over another. Determine which types of property are easier to close, and which types are more likely to present challenges.
Typical loan transaction processes for commercial properties are also commonly longer and more complex than residential properties.
“Traditional lenders may take several months to close commercial loans, though non-bank alternative lenders are often able to shorten the process,” Silver Hill writes.
Knowing the different qualification standards for commercial versus residential real estate is step two. Residential lenders focus on qualifying the borrower, whereas commercial lenders focus on qualifying the property.
“Of course commercial lenders qualify borrowers as well, but their underwriting teams spend a significant amount of time determining the subject property’s ability to generate revenue,” according to Silver Hill.
This brings us to the debt service coverage ratio (DSCR) which is calculated by taking a property’s net operating income (NOI) and dividing it by debt service (principal and interest amounts). The underwriter’s goal is to determine whether or not a property produces sufficient revenue to appropriately satisfy the repayment of a loan.
If you’re new to commercial lending, give yourself ample time to familiarize yourself with the commercial lending underwriting process before you start prospecting for commercial business. Be aware that lenders may require certain documentation that differs from that required for residential approval, and the overall process may take longer than expected. Only once you have a full understanding of the nuances in commercial lending can you pass along that knowledge to prospective borrowers, and help them to understand how lenders review commercial loan requests.
Recognizing the contrast between commercial and residential loan terms is step three. Commercial mortgages typically have term lengths of 5, 7, or 10 years due to the increased risk associated with commercial loans, whereas residential mortgages are most commonly 30 years in length. As a result, refinancing a commercial borrower’s mortgage happens much more frequently. Some commercial borrowers may welcome the flexibility of short-term loans while others would prefer a long-term solution with a fixed rate.
Silver Hill recommends focusing energy on creating and maintaining long-term relationships with commercial clients.
“If you provide them with a remarkable lending experience, they will likely come to you for their future refinances. This can be a good thing for originators who specialize in creating strong relationships with their clients,” said Silver Hill. “There is an opportunity for repeat business that doesn’t exist with residential borrowers.”