Taking out a mortgage to purchase commercial real estate, or CRE, has some steps that are similar to what you would need to purchase a residence, but the steps toward that mortgage are a little different. Individuals and entities take out CRE mortgages when they want to finance hotels, retail malls, office buildings and complexes, shopping centers and other similar structures. Much like a residential mortgage is a loan secured by the property, a commercial mortgage has the same security.
Taking out commercial mortgages in Ontario, though, has some steps that differ from the residential process since the loans are different in a number of ways. Take a look at the primary differences:
Organizations and entities take out commercial mortgages more frequently than individuals do.
The vast majority of residential mortgages are taken out by individuals wanting to purchase residences, either to live in as a primary dwelling or to serve as a vacation residence, or to make rental income. However, loans for CRE are frequently issued to such entities as corporations, developers, limited partnerships, funds or trust. In many cases, these entities have been set up for the sole purpose of acquiring commercial real estate.
Individuals taking out a residential mortgage are often screened for their credit history, but in the case of entities looking to take out a commercial real estate mortgage, there may not be a credit history or other financial documentation to screen. In those cases, the lenders may require that the entity’s owners (the principals) personally guarantee the loan. After that, the lender will go through the principals’ financial information, and if the loan goes into default, the lender can go after the principals. The other, less common, option here is a non-recourse loan, in which the lender does not secure a guaranty from the principals, and if the loan goes into default, the only remedy for the lender is to seize the property.
Commercial mortgages frequently have longer amortization periods than the terms of the loan.
For borrowers in Canada, this is the same situation that one finds with residential mortgages, because the longest term one can find in a loan is ten years, but amortization periods for residential mortgages can run 20, 25 or even 30 years. The shorter the term, the lower the interest rate, but then the borrower has to go through a renewal process each time a term comes to an end.
In the case of a commercial mortgage, there is a balloon payment waiting at the end of the term. If the entity that took out the mortgage cannot pay the full balloon payment, then it also has to go through a renewal process or transfer the debt to another lender. If the borrowing entity has the money on hand to pay it off, then the entity can obviously satisfy the debt in full without having to renew.
The length of the amortization period is linked to the interest rate that you are likely to get; the longer the history of the period and the term, the higher the interest rate, because the longer the risk that the lender is taking.
The loan-to-value (LTV) ratio in a commercial mortgage often has to be lower than it would with a residential mortgage.
The LTV ratio measures the value of a loan in relation to the property’s value. A lender determines a mortgage’s potential LTV ratio by dividing the requested loan amount by the property’s appraisal value or the property’s purchase price – whichever number is lower. So if your entity wants a $600,000 loan on a $1,000,000 property, the LTV would be 60 percent. The lower the LTV ratio, the lower the interest rate in the majority of cases, because there is less risk for the lender – since the lender has to assume less equity.
Many residential mortgages come with an LTV that can run as high as 90 percent, and even higher for some special cases. However, in Ontario, the majority of commercial mortgages cannot have an LTV ratio higher than 75 percent, and the most common range runs between 65 and 75 percent; with some special insured and/or government backed programs exceeding 75%. In cases of loans for the purchase of raw land, the maximum on LTV ratios is often as low as 50 percent.
Lenders also look at debt-service coverage ratio for commercial real estate mortgages.
The debt-service coverage ratio (DSCR) measures a property’s net operating income with respect to the debt that is attached to the property, including principal and interest. The purpose of this ratio is to determine whether a particular property can pay for the debt attached to it with the revenue that it generates going forward.
Let’s say a property brings in $500,000 in NOI (net operating income) per year and has $300,000 in yearly mortgage debt service. The DSCR would be 1.67. Lenders use this ratio to determine the maximum size of the loan they should extend for a property on the basis of the cash flow.
A DSCR of 1 means that the property brings in exactly enough cash to pay for the loan that the property secures. In Ontario, commercial lenders often require a DSCR that is at least 1.25, so that the cash value will continue to cover the demands of the loan. There may be flexibility for borrowers willing to take shorter amortization periods or in the case of properties that have stable, high cash flows. However, in the case of a property that has an unstable cash flow, such as a hotel, the ratio requirement could be higher.
Commercial mortgages often come with higher interest rates.
This is an acknowledgment of the simple fact that the risk with a commercial mortgage is higher, even after accounting for the lower LTV ratios. The principals making the guaranty for the mortgage would allow the commercial loan to lapse before they would put their residential mortgage in jeopardy – making the risk higher.
Are commercial loans hard for you to come by in Ontario? Give us a call at Amansad Financial. We have built a lending network for individuals and entities seeking CRE loans, even if the traditional lending community has already denied their applications. We also can connect clients with private funding sources looking to invest in borrowers who don’t quite have the right metrics to satisfy the traditional lenders. Reach out to us today, and we will go over your commercial lending needs and recommend the best solution for you.