A major distinction between the residential and commercial real estate business sectors are in the markets and methods of financing. The use of buildings as collateral to borrow money is what drives both industries, but similarities between the finance of commercial and residential real estate more or less end right there. Residential practitioners considering commercial deals would do well to educate themselves deeply on the particulars of CRE finance before jumping in. Naturally, NAR and NAR Affiliate education offerings abound for this.
But just to keep it on a conversational level: what are the biggest differences between the two?
Terminology And Contexts
Residential practitioners use a wide range of financial terms that have no parallel in commercial real estate. There’s no such thing as a commercial HELOC, nor “stated-income” loans. But a look at terminologies between commercial and residential shows that residential’s particular jargon is very limited in comparison to that in commercial. This is because residential real estate is very narrowly defined, and commercial spans everything residential doesn’t.
Fannie Mae defines residential properties as single-family homes and multifamily dwellings of four or fewer units. That leaves literally every other kind of real estate out of the residential classification and by default in the enormous and complex definition of commercial property. If it’s not residential, it’s commercial. Land, industrial, income-producing, non-income-producing, retail, office, you name it. There are hundreds of different types of commercial property.
Lenders For Every Property Type
Commercial presents a far greater degree of specialization in capital sources than residential. For as many kinds of commercial property that exist, there exist lenders and terms tailored to that type of property.
Take retail. Consider how many significantly different shades of retail spaces exist: there are strip centers (not anchored by a grocery), neighborhood shopping centers, big-box power centers, shadowed anchored centers, high-end specialty, and more.
Capital sources for each type of retail present different financing propositions, because the cash flows that the properties create are all different and all critical to the lender’s profitability on the loan. Interest rates tend to be lower for anchored properties, higher for strip-type shopping centers. Compared to residential, commercial property lending goes for depth rather than breadth: hardly a bank is in business that doesn’t do home loans, but many lenders just don’t have the background to do some kinds of commercial loans.
The understanding of cash flow for a business and the building of future expectations against that understanding is something a lender needs in order to lend to a business. And it’s also the same reason lenders prefer not to lend to businesses, but to landlords who lease their properties to businesses. Commercial property is far easier to analyze and is much more predictable to lenders than the business of commercial tenants is.
In residential real estate, where there is no actor comparable to the commercial property landlord, lenders focus on creditworthiness of homeowner-borrowers (and, to disastrous effect a few years ago, sometimes focus on things other than creditworthiness). While not without its own risks, the residential financing side of the real estate business enjoys a limited set of decision factors compared to the commercial side.
(Photo credit: Tax Credits)