Analyzing Islamic Commercial Transaction

Right off, there’s a big difference between residential and commercial real estate that you need to know about. Basically, commercial real estate (CRE) is income-producing and used for business purposes like hotels, offices, apartments and even retail centers.

It stands to reason that the financing for these loans comes from a different source as well, in that commercial real estate loans are essentially mortgage loans that involve themselves with commercial rather than residential concerns.

One of the things that are similar between commercial and residential mortgage loans is the fact the lenders need to be involved with both. However, there are other players when it comes to commercial loans like pension funds and insurance companies, as well as private investors.

The US Small Business Administration’s 504 Loan Program is also involved when it comes to supplying loans for commercial real estate. Of course, there are some other differences between residential and commercial real estate loans, and this article will put them into focus.

The name of the commercial real estate loan itself should tip you off to one of the major differences, and that’s the fact that while individual people looking to buy homes make up the bulk of residential real estate transactions, commercial real estate loans are usually made up of business groups that are looking to buy some kind of real estate. These groups often take the form of partnerships, corporations, developers, trusts, and funds. These groups are often referred to as entities.

These entities are put together specifically to purchase some commercial real estate, and they might not have any credit history of their own. For that reason, the owners may need to provide a credit history for the group that is looking to buy the real estate, and the process here is called guaranteeing the loan. This is a method whereby the lender can recover their costs if the loan defaults.

However, if the property is the only way to recover costs after a loan default and the lender doesn’t require the other option, the loan is called a non-recourse loan since there is no other way to recoup except through the property.

The repayment schedules for commercial loans are different as well. A residential loan that an individual takes out has several different options where the whole debt is paid out through installments over a period of time. The longer the amortization period, the smaller the monthly payments, but the higher the cost of finance.

The residential loan is set up or amortized so that the entire amount is paid off by the end of the loan term. Currently, most people can choose from twenty-five, fifteen, and even thirty-year mortgages.

The commercial loan has a few caveats that make it different than its residential cousin. The terms on these loans generally range from five years or under, all the way up to twenty years. Here, the amortization period is often longer than the term, and this simply means that the investor makes the payments until the end of the term with one final larger payment to pay the loan off in full. With these commercial loans, both the term and the amortization numbers are deciding factors in the rate the lender charges.

The loan-to-value ratio (LTV) is another real way that these two types of loans differ. Like the name suggests, this is a metric that measures the value of the property against the monetary value of the loan.

The calculation is done this way: the loan’s amount is divided by the number that is lower between the purchase price of the property or the appraised value of the same. The final number is presented as a percentage. Here’s an example. A $90,000-dollar loan on a property that costs $100,000 would be 90 percent.

Although this ratio applies to both commercial and residential mortgages, the ratio levels that are acceptable for each differ. This occurs in spite of the fact that as a general rule, people with lower LTVs will get better rates from lenders since they generally have better equity.

There are some residential loans that allow for LTVs up to 100 percent, and these types of loans include USDA and VA loans, to name a few. There are a few others that can get away with LTV percentages in the high nineties, and these include FHA loans insured through the Federal Housing Administration and other more conventional loans guaranteed by Freddie Mac or Fannie Mae.

There is a lower acceptable percentage for commercial loans when it comes to these LTV numbers and they generally fall to within the 65% to 80% range. The specifics here often depend on the category the loan falls into. Raw land is an example where an LTV of 65% is possible, while for multi-family construction structures, you might even get away with an LTV of up to 80 percent.

Remember, in commercial lending, there are no VA or FHA programs and no private mortgage insurance to speak of. Therefore, lenders use the real property as security.

There are other factors that need to be looked at. In fact, the debt-service-coverage-ratio (DSCR) is another metric that commercial lenders use. (This measurement is a property’s ability to service debt by comparing the annual net operating income against the property’s annual mortgage debt service.)

What’s important here is the fact that the DSCR’s value needs to be higher than 1, or there’s negative cash flow. As a general rule, commercial lenders prefer this number to be at least 1.25, so there’s an adequate cash flow. Shorter amortization periods can make lower scores here acceptable, but properties with volatile cash flows like hotels, where there’s typically no tenant lease, means a higher ratio is often required.

Of course, no discussion on commercial real estate loans would be complete without mentioning rates and fees, since these are two factors that further differentiate these products from residential loans.

The rates on commercial loans are typically higher, and the loan application, appraisal, legal, and other fees are generally more expensive. Some of these even need to be paid before the loan is processed. There are often restrictions on prepayment, which mirror their residential counterparts.

Although these can generally be negotiated before the terms of the loan are finalized, these early exit possibilities fall under four broad categories.

• Defeasance. This is a substitution of collateral where the borrower replaces cash paid to the lender with something like Treasury securities in its place. There are high penalties associated with this method.
• Lockout. There is no possibility for paying off the loan at a specific time, which is usually five years.
• Rate Guarantee. Like the name suggests, the lender gets a specific amount of profit here even if the loan is paid off early.
• Prepayment Penalty. The most common where the number is arrived at by multiplying the current balance by a predetermined amount.

The basic difference between commercial and residential can best be summed up this way. A business entity is usually the investor for the commercial products, and the idea is generally to lease or rent the spaces out and make money.

For these commercial loans, lenders generally look at a different set of criteria that include three to five years of financial statements and the financial ratios already mentioned in this article.