Residential and Commercial Real Estate Comparisons
Comparing Commercial and Residential Real Estate
The real estate industry has exhibited problems and uncertainty during the past decade. Some of these factors primarily impacted residential real estate while others were primarily relevant to commercial real estate. In a small number of cases, both sectors were effected by the same elements. These differences serve as a valuable illustration of how residential and commercial real estate often operate independently.
There has been considerable media coverage discussing whether or not it is time to think about buying real estate again. What is often missing in such discussions is whether the advice applies equally to commercial and residential real estate.
The purpose here is definitely not to suggest recommended timing to purchase real estate. My immediate goal is to provide an introduction to the most critical financial and business differences between residential property and commercial property. By comparing commercial and residential real estate in this way, my secondary goal is to illustrate how different it might be to invest in residential properties in comparison to commercial properties and businesses.
Tax Returns and Financial Statements
The financial documentation requirements differ substantially for financing various categories of real estate. Personal tax returns are a primary requirement to buy a single-family home whether it is for personal or investment purposes. When buying a business property, a lender will typically request business tax returns and financial statements as well. From a commercial loan underwriting perspective, two to three (or more) years of profitability will be a normal lending expectation.
Can Homes Be Commercial Real Estate?
When an individual buys a single family home for investment purposes, a lender will treat that differently than if a home is being purchased to serve as a personal full-time residence for the buyer. For example, there can be a higher down payment (possibly much higher). It is also likely that the length of the loan will be shorter and involve a higher interest rate. Buying a single-family residence as an investment property does not involve working with a commercial lender, and the mortgage is not treated as a commercial loan.
When multi-family apartments are involved, the lending standards move into new territory that will not be discussed in detail here. A common standard is for there to be five units or more to be classified as a commercial mortgage. In some limited cases, a buyer purchasing five or more single-family homes (for rental purposes) that are located contiguously could qualify for commercial real estate financing if certain conditions are met.
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Of course, a comprehensive real estate dictionary cannot help you answer all of the questions that you should be asking about both commercial real estate and residential real estate. A case in point is the risk involved with real estate loans.
Risk measurement for small business financing is an activity that commercial borrowers probably gave little or no thought to until most banks and other commercial lenders stopped making even routine business loans to small businesses throughout the United States. While most bankers have portrayed their dramatically reduced levels of working capital financing and commercial mortgages as something that should not be of real concern, the failure of banks to sustain anything remotely close to a normal amount of commercial financing should serve as a meaningful warning to all concerned. This article and others by Steve Bush will continue to describe a number of commercial finance risks that should be measured by small business owners as a critical part of their financial decisions. The most practical and effective small business solutions currently include commercial bank consulting and business finance contingency planning.
A funding solution from banks is not routinely appearing for business finance needs that most owners currently have. Banks have been the traditional source of small business loans for several decades, but this role seems to be growing to a close. As a result, it has become essential for borrowers to both evaluate their commercial finance needs and find new sources for commercial financing and working capital loans.
Nevertheless, part of the ongoing challenge in understanding either residential or commercial real estate is the terminology — here's a book that will help you to overcome that difficulty.
Length of Investment
Both residential real estate and commercial property represent long-term investments and commitments. Anyone who suggests that a short-term perspective is possible in real estate is not being prudent. Many people were surprised by how quickly the real estate market changed several years ago. Much like investing in stocks, there are ups and downs in small business economics and the real estate economy.
A realistic goal is to have a profitable long-term investment. The path to achieving this involves much more than "buy low and sell high." For investment property, managing the income produced can be as important as the sales price.
The concept of a reverse mortgage applies only to residential real estate financing for a property occupied by the borrower(s). This exotic and complicated form of financial instrument involves far more fees, problems and risks than any potential benefits.
In terms of potential complications and ongoing risk-related issues, reverse mortgages can best be understood by comparing them to payday lending schemes: a typical reverse mortgage is a financial product that was devised to benefit lenders and salespeople much more than the borrowers and recipients of an income stream. Much like payday loans, reverse mortgages are too-often used when individuals feel that they have no other realistic alternatives when funds are needed. "Beware" is my final word of caution.
Residential financing rarely if ever involves a requirement for the borrower to provide additional collateral. However, in the world of small business financing, collateral can be required by some banks. When a lender requires a commercial borrower to use their own home as collateral, this is often referred to as "cross-collateralization." Such bank loan requirements should be avoided whenever possible.
A business plan is often required as part of the commercial real estate lending process. Such requirements are not likely when buying a single family home for rental and investment purposes. While business plans are not always mandatory for business financing, such a requirement will add to both the length and cost of the lending process.
While a prepayment penalty can sometimes appear in either commercial or residential financing, a "lockout penalty" is unique to commercial loans. Lockout penalties are much higher than prepayment penalties and should be avoided. Such a penalty often lasts up to five years and can prevent refinancing or selling during the prescribed period. Business negotiating with your banker is always advisable, but it is especially critical to make every effort to avoid this excessive banking condition.
Buying a Business
If an individual wants to buy a business rather than a single-family home as an investment and needs bank financing, a commercial loan will be required. Loan underwriting standards will depend on the creditworthiness of the buyer as well as the type of property and business involved. If the business being acquired does not include real property, then "business opportunity financing" will be required. For example, when buying a restaurant that leases rather than owns its location, the purchase will not include the building. As part of a business opportunity loan process, the lender will generally impose specific requirements about the underlying lease.
Real Estate Appraisals
The cost and length of the appraisal process is significantly different for residential and commercial real estate loans. While the appraisal for a single family home might be completed in several hours and cost a few hundred dollars, appraising a commercial property and business typically costs several thousand dollars and often requires a month (or more) to complete. For complicated and specialized businesses such as funeral homes, the cost and time requirements are even higher.
The continuing presence of "Zombie Banks" is a potential problem for both residential and commercial real estate financing. Questions to address include:
- Is my bank a Zombie?
- Should I fire my Zombie Bank?
- What if my banks says no?
- What is Plan B?
Practical solutions will usually include improved business communication with potential lenders.
As outrageous as payday lending schemes are, I consider reverse mortgage programs to be even worse for borrowers because the problems and risks are less obvious.— Stephen Bush
© 2012 Stephen Bush