Commercial mortgages are very similar to residential mortgages, but there are some key differences. One of the most important is in the way lenders view commercial mortgages versus residential mortgages. Generally, lenders consider commercial mortgages to be much riskier, and this is reflected in more stringent lending criteria and higher interest rates.
Commercial Mortgage Lenders
Most banks and other conventional lenders offer commercial mortgages, but as with residential mortgages, you must satisfy certain lending criteria.
The main criterion lenders use to assess commercial mortgages is called the debt service coverage ratio, roughly defined as the ratio of the amount of loan payments versus the cash the business has available. Some lenders are willing to accept higher-risk applications where the business has a relatively poor credit history, however most lenders require that the business has a good credit history and is creditworthy.
In addition, lenders typically apply a loan-to-value ratio to the mortgage application, and on that basis will require the owner of the business to invest a proportion of their own personal cash in the purchase of the property. The LTV is a measurement of the amount of money being borrowed and the actual value of the property.
Lending institutions typically view commercial mortgages as high-risk ventures as compared to residential mortgages. This means that in addition to more stringent lending criteria, applicants generally face higher interest rates. The interest rate on a commercial mortgage can be up to 2% higher than an equivalent residential mortgage (interest paid on commercial mortgages is tax deductible as it is with residential loans).
Another feature of commercial mortgage lender requirements is that commercial mortgages are available at lower loan-to-value ratios than are residential mortgages. Residential mortgage lenders usually prefer the LTV ratio to be at least 80% (meaning that the amount of the mortgage is more than 80% of the value of the property). However, because lenders view commercial mortgages as having a higher risk, the LTV ratio is usually somewhere between 55% and 70%. It is possible to locate commercial mortgage lenders who will offer higher LTV ratio loans, but higher interest rates are a given due to the higher risk of the loan.
Finally, there is the mortgage itself. The typical commercial mortgage is very different from most conventional residential loans. A thirty-year fixed-rate residential mortgage, for example, involves monthly repayments that stay the same over the life of the loan. A commercial mortgage, on the other hand, is more similar to a balloon mortgage. Commercial mortgages have much shorter terms, with monthly repayments made for a relatively short period of time, after which the balloon payment is due. Generally commercial mortgage repayments are made according to a thirty-year amortization schedule, but the balance of the loan is due after ten to fifteen years. At the point at which the balloon payment is due, the borrower can pay the loan in full or refinance. It is uncommon for refinancing to be carried out before the balloon payment is due, because commercial mortgages tend to have heavy early-payment penalties.
Many commercial lenders also offer adjustable rate commercial mortgages, as well as other variants such as convertible rate mortgages (in which the loan starts out as an ARM but allows the borrower to convert to a fixed rate mortgage at any time).
Getting a Commercial Mortgage
The process of evaluating the credit-worthiness of even a small business is much more complicated than examining an individual credit rating. In both cases a lender will require information such as proof of income, assets, and debts, but in the case of a commercial mortgage, lenders require a significantly larger amount of information before a mortgage is granted.
One of the key differences is that for commercial mortgages, the credit rating of any one individual (even the owner of the business) is irrelevant. Instead, documents such as balance sheets, cash flow statements, and profit and loss statements, are much more important. Lenders prefer to see at least two years’ worth of these documents, all of which must be prepared by a certified accountant, so unless you are a certified accountant yourself, you can’t the prepare documents for your own business.
When evaluating a commercial mortgage application, lenders also consider not only the credit-worthiness of the business, but also the status of the building being purchased. Lenders evaluate the condition and location of the property, the purpose and function of the business and the property, and the past and projected future revenue of the business. In cases where the business is a new venture, the lender may also want to see a business plan before granting a mortgage.
Jeremy Foster is a freelance writer who writes about financial products pertaining to the mortgage industry such as the
lowest mortgage rates.
