Residential vs commercial mortgage lending, the asset may be real estate but all other comparison stop there. In the case of residential, the borrower often resides in the property and as such it provides no income from a tenant. If the property is leased, in Australia the net (commencing) annual income returns from leasing a residential property vary between 2.75% to say 5%. In this form of lending the lender pays close attention to the borrower’s ability to service the loans interest payments from their surplus income.

Commercial real estate such as offices, industrial and retail is usually leased to 3rd parties, with leases varying in duration from a few months to say 20 years. The leases are typically subject to a range of terms and conditions that govern usage, frequency and the basis of rent reviews etc. As well, the net Income returns from commercial real estate are typically much higher than that from residential property and might range from 5% to 10-12% and sometimes higher, depending on the property, its location, the credit quality of tenants and the terms and duration of leases. When lending on commercial property the lender pays close attention to the tenants and lease terms and competition to the asset. It’s also the case that commercial property borrowings are often further supported by way of guarantees from the borrower, both corporate and individual, which add an additional layer of security.

Residential property lending is largely the domain of banks, building societies and the like, who often use the residential loan as an opportunity to gain other financial relationships with the borrowers. As well, residential lending is frequently at a lower interest rate than commercial lending and at a higher loan to valuation ratio (LVR), which simply means the amount of the loan expressed as a percentage of the value of the property.

The reason investors are attracted to Investing in commercial real estate loans is that they provide regular and predictable income and are a lower order of risk than that of direct property ownership. The lower order of risk occurs because the borrower will have a significant equity position in the loan for example if a property is valued at say 100 and the loan is for 66, then the equity is 34% (100-66) or the Loan to value Ratio is 66%. In the event of default, for an investor to lose money, the net value of the realised asset (i.e. monies outstanding netted against the value of the property), including; capital, interest income and default income and any costs must decline by over 30%.

It is also important to understand that the loan terms and conditions for commercial real estate lending are designed to cover risks and provide boundaries within which the borrower must perform. These include:

• the date loan interest is due, number of payments, term of loan and default interest
• the amount lent
• the level of loan to value ratio that must be maintained during the term of the loan
• the form and type of insurance that must be maintained
• how tenancy and tenancy changes must be handled (generally these need be approved by the lender, before they can occur)
• minimum levels of debt service coverage (both from the property asset and “all sources” (all sources refers to a borrowers surplus income from their employ or other assets/businesses) that must be maintained

As well, certain types of commercial loans may also have a range of other loan conditions, such as the sale of a certain number of assets in the case of loans which contain a number of strata properties to reduce the size of loan or it’s LVR over time.

All of these are designed to mitigate risk and when combined with the special terms and conditions there will be certain penalties for failure to meet a condition or rectify it within a given period. These penalties may include an increase in the interest rate but may under certain circumstances escalate to the matter becoming an event of default.