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Commercial mortgages explained

by Corben Grant on 05 May 2022

As a real estate investor, you have many different options when it comes to where you want to put your money in order for it to grow. One of the most popular options is in the residential sector through things like rentals or flipping, but you may also be interested in venturing into the wide world of commercial real estate.

Commercial real estate offers investors a whole range of new property types and ways to increase their wealth. However, commercial and residential real estate investing can be pretty different beasts and if you assume that everything is the same, then you’re going to be in for a rude awakening. One major difference is that commercial spaces can be much larger than residential homes. Though there are small commercial spaces, there are also things like large warehouses, office buildings, or apartment towers. These buildings are not only bigger in size, but can also be much more expensive.

How can you get into commercial real estate investing if the prices are so much higher? Well, just like in residential real estate purchases, commercial buyers can get financing for their property purchases. These commercial mortgages work on the same basic principles as residential mortgages, though the devil is in the details.

If you are just starting out in commercial real estate investing, you may not have the capital to be buying properties outright or the experience required to find other sources of capital. For someone like this, a commercial mortgage is a good option. In this article, we will explore everything you should know about commercial mortgages. We will cover how a commercial mortgage works, how they differ from residential mortgages, how to qualify for a commercial mortgage, and more.

What is a commercial mortgage?

In the most basic sense, a commercial mortgage works like a residential mortgage. A buyer who is interested in purchasing a property approaches a bank for financing. The bank will assess the opportunity and, if approved, offer the buyer a loan to purchase the home which is paid off with regular mortgage payments over a set period. The bank makes money on the deal by charging interest on the loan.

Commercial properties are a unique and distinct asset

One obvious difference right off the bat that makes commercial mortgages different is the property type in question. Residential mortgages are only available for residential properties like detached homes, townhouses, and condominiums. Commercial mortgages include things like retail buildings, offices, industrial buildings, multifamily units, and more. These different properties have their own features, risks, and investment strategies that necessitate a slightly different approach to financing.

Why do we need special mortgages for commercial real estate?

There are a couple of reasons why banks are not willing to offer the same mortgages between residential and commercial properties and one of the biggest differences comes down simply to the use of the property. Because commercial properties are used for business purposes, they are valued a little differently. This means that when you apply for a commercial mortgage, the building's value, not just as a physical building, is taken into account, but also the building's potential income-producing value.

While some residential spaces do produce income, the scale is much more different than with a commercial property. This also means that the mortgage lender needs to be more thorough in assessing the property's eligibility and it may take longer to get a commercial mortgage finalized. Also, commercial and residential properties represent different levels of risk. The ability of an investor to pay off a loan relies on their ability to generate income, run a successful business, or find reliable tenants, which can be less reliable in some segments of the commercial space. Areas like retail have faced demand issues in recent years when compared to something like residential units where it may be easier to find tenants.

Finally, these different mortgage loans often appeal to very different consumers. Since commercial properties are used for business, the buyers of these properties are often businesses and corporations. These corporations are going to have very different goals, needs, and financial profiles compared to a regular residential investor so the bank offers different mortgages to meet their needs. Lenders may also offer various different mortgage products depending on the property type and use case.

Consulting the help of a commercial mortgage broker and other professionals

Getting a commercial mortgage can be a lot more complicated than a residential mortgage and that's after whatever relevant due diligence you had to go through in business planning and choosing a property that works for your business. However, making the right decisions about which property to buy and what sort of mortgage you get can have a huge impact on your investment success.

Before taking on a commercial mortgage, you should seriously consider working with a commercial mortgage broker to help you understand your options and find the most competitive interest rates. You should also consider speaking with other professionals such as real estate lawyers and business planners to make sure you are approved quickly and your business or investment is successful.

Commercial mortgage terms

Commercial mortgage terms can vary a lot from property to property, but here are some general terms you might expect to receive for a commercial mortgage loan.

Commercial mortgage rates

In terms of interest rates, you can get both fixed rates and variable interest rates for commercial mortgages. Just remember that interest rates in commercial properties can be much higher than in residential mortgages.

Mortgage term length and amortization period

Another difference is the term and amortization periods of commercial mortgages. Commercial mortgages generally have terms from five to 25 years in length and amortization periods can go as far as 40 years. These are both much longer than your standard residential mortgage.

Down payment requirements

Commercial mortgages also have higher down payment requirements than residential mortgages. The minimum is 85% loan to value and can go as high as 50% for vacant land or farmland. Your required down payment may vary a lot based on your property type and use.

CMHC insured commercial mortgages

Some commercial mortgages are also able to take out mortgage default insurance from the Canada Mortgage and Housing Corporation (CMHC).

Generally, CMHC offers this insurance to multi-unit residential properties. CMHC insured mortgages are offered better rates by lenders as there is less risk in these mortgages, however, borrowers must also pay to cover the insurance premium and meet a set of qualifying criteria.

Criteria for qualifying for CMHC insurance on a commercial property

Some of the criteria required to qualify for CMHC commercial mortgage insurance may include:

  • Having at least five or more units
  • Property is at least 70% residential both in floor area and loan value
  • Have a loan to value ratio no higher than 85%
  • Proven experience in managing similar rental properties
  • At least five years of multi-unit management experience from the borrower or their property manager
  • Net worth of at least 25% of the loan value
  • Capable of guaranteeing up to 100% of the loan until you have 12 months of stable rent

These criteria can make CMHC insurance on commercial mortgages much more restricted than on residential mortgages, however, there are benefits for both the lender and the borrower.

What you need to qualify

When it comes to qualifying borrowers for commercial mortgages, commercial lenders go a bit beyond what is required in conventional residential mortgages.

Personal financial record

Like with any loan, the borrower's own financial situation will have to be taken into account when qualifying for a loan. These factors include things like the borrower's credit score, income, debt service capabilities, and more.

Property type, business plan, and business success

The other component of qualifying for a commercial mortgage comes down to the property itself – how much income it can generate and how you plan to run your business.

If you have an existing business, commercial mortgage lenders will want to know that your business is profitable and sustainable before they qualify you for a loan. Otherwise, they may also want to see a business plan that outlines what you plan to do with your property once you own it and how you will use it to generate income.

This allows them to make sure you are going to be able to cover your payments. In addition, they may want to verify your net worth or savings in order to make sure that you are able to cover payments for a period if your property fails to produce income.

The type of business you are choosing to operate or the type of business tenants you plan to rent to may also play a role in your mortgage qualification and terms. Some industries are in more or less demand in certain areas and will make a loan more or less risky for your lender.

Finally, as mentioned before, you will need to have a certain amount to put forward for a down payment. Generally, the higher the down payment the better, especially if the bank sees your loan as risky. Having a higher down payment will make them more willing to work with you and provide more favourable terms.

Conclusion

Commercial mortgages make getting into commercial real estate investing much easier, just like residential mortgages make buying a home easier. Though there are some big similarities between commercial and residential mortgages, there are also many important differences.

For someone looking to get into commercial real estate investing, understanding how these mortgages work may be crucial to getting your start. If you still aren't sure if commercial real estate is right for you, you may want to learn more about the benefits of this kind of investing, or other ways you can finance your investments.



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