There is quite a difference in the process of obtaining a commercial real estate mortgage versus obtaining a loan to buy or refinance residential property. In this article we will examine some of those differences and basic qualifying criteria.
Lending guidelines have tightened recently because of the sharp upswing in defaults and foreclosures. Residential mortgages, though, are still easier to qualify for, because it is felt by most lenders that a homeowner will struggle hardest to retain their residence. That is why "owner-occupied" homes get a lower interest rate than second or investment homes. If times get tough, an owner might walk away from a vacation cabin or investment property, but would probably persevere to the last degree to keep the home they live in.
Similarly, someone is more likely to let go a commercial property than their own home. Additionally, most businesses are incorporated. A corporation is a legal "person" separate and distinct from its owners/shareholders. It has its own credit rating and shareholders, except in the case of brand-new corporations, are not usually on the hook for the liabilities of the corporation. If the corporation defaults on a loan, the lenders can only attach assets of the corporation itself, not the assets of the owners.
For this reason, increased risk, commercial real estate mortgages are made at higher interest rates than residential loans. They also require more paperwork.
For purposes of this article, we will examine the typical loan process for a small business corporation, not a Fortune 500 company. Let us use the following scenario:
James and Grayce own a store that sells newspapers, magazines, cigarettes and lottery tickets. The store is located on the ground floor of a three story building in a commercially-zoned part of Main Street. They live upstairs on the second floor. The third floor is divided into several offices they rent out to an attorney and some other small businesses. They have owned this building and their own business for 5 years. They have made good money and feel they are now in a stronger credit position and would like to refinance the building and lower their monthly mortgage payments.
This type of structure is termed "multi-use" because there are both commercial and residential portions in one building.
Their bank asks for the following documents from James and Grayce:
- Past 2 years personal income tax returns including 1099 or W-2 forms, depending upon how they pay themselves
- Copy of all business licenses and permits
- Past 2 years corporate tax returns and audited financial statements prepared by their CPA
- Copies of leases for the third floor commercial tenants
- Past 6 months personal and business bank statements, all accounts
- List of all other real estate they own including value, mortgage balances, etc.
- Copy of previous year's property tax bill and copy of property insurance policy and invoice
- Appraisal - a commercial appraisal can cost $1500 or more, compared to $300 or so for a residential appraisal
The bank is going to analyze these documents to see the following:
- Have James and Grayce made their personal as well as business debt service payments on time?
- How much is the building worth and how much do they owe? This is called Loan-to-Value Ratio (LTV)
- What is their income versus how much they pay out for debt service? This is called Debt-to-Income Ratio (DTI)
- How much rent do they collect? 75% of this amount will be able to be considered as "income" and 25% is disregarded to allow for vacancy, repairs, etc.
- Their net worth: Assets-Liabilities=Capital
James and Grayce are fortunate to have been in business five years so they can provide good, solid documentation of their income from the business. They have paid all debts on time. The tenants on the third floor have been there for years and always pay on time. The building has appreciated quite a bit since they first purchased it so their LTV is low. They will most likely be approved for their refinance.
One word of caution concerning financial statements for self-employed persons: it is understandable and normal that your CPA will endeavor in every legal way to reduce your tax bill by minimizing your net income. This done by making sure to document all business expenses and deductions, among other methods. The tax return prepared will give you the lowest possible tax bill. But when it comes time to use those same tax returns to prove your income to a lender, you may feel frustrated because your "real" income is much higher than what is reflected on those returns. Well, "you can't have your cake and eat it, too." However, many lenders will look at other income documentation such as bank deposits to verify what you "really" earned. If you did not deposit a lot of cash you not only probably broke the law but you are now going to be unable to prove your "real" income to prospective lenders. So bear this scenario in mind if you are self-employed and own or wish to own commercial property or even for purposes of purchasing and refinancing residential property. The tax savings from "creative" tax strategies may be eaten up down the road by your being forced to accept higher interest rates on loans. Just something to ponder...
As always, you may wish to consult with a Mortgage Planner and a CPA before any purchase or refinancing of commercial or residential real estate.
