Commercial vs. Residential Lending
When obtaining financing to purchase a home, it’s a residential loan that is made. Such loans are issued for both owner-occupied and investment properties for single family homes, 2-4 unit properties and condominiums. When qualifying for a residential loan, lenders primarily evaluate both the applicant as well as the subject property. Both must meet standard guidelines. Borrowers must be able to afford the new mortgage, have good credit and show enough assets to cover the down payment and closing costs. The property is evaluated by comparing recent sales of similar homes in the area and comparing the subject property’s sales price with recorded sales of other properties.
Commercial lending is a bit different. What exactly is commercial lending? Any structure with five or more attached units is considered commercial even though the individual units will be someone’s home. If you think of an apartment building that could be financed with a commercial loan. As with residential loans, the borrower or borrowers are also evaluated based upon capacity to pay, credit and available liquid assets. And also as with residential loans the property is also evaluated. There are three primary methods to evaluate the current value of a commercial property, Cost, Market and Capitalization.
The cost approach really isn’t used very often and attempts to arrive at a value based upon how much the subject property would cost if built from the ground up. This is an expensive method and requires first-hand knowledge on construction and labor costs, fees, permits and zoning requirements.
The market approach is very much how residential properties are evaluated. In this fashion, the subject property is compared with recent sales of similar commercial properties in the area. The challenge with this approach is finding similar recently sold properties in the area.
The capitalization approach is more commonly used when arriving at a value based upon the capitalization rate, or cap rate of a property. The cap rate is relatively easy to figure once basic data is known. The cap rate is expressed as a number with the higher the number, the better the return.
To figure the cap rate, you need to first add up gross income from the property. Next, subject expenses such as property management fees, taxes, insurance and other required charges. The cap rate divides the net income by the original purchase price. For example, if net income from a rental property was $10,000 per year and the purchase price was $100,000, the cap rate would then be 10. If the net income were $6,000 per year in this example the cap rate would be 6.
Real estate investors can compare the subject property’s cap rate with cap rates of other similar properties in the area. The highest cap rate provides the investor with the highest return.