Why Are Commercial Mortgages considered "more risky" Than Regular Home Mortgages?
Hi everyone,
So what I'd let to get some clarity on is an example like this:

Lets say I get a commercial mortgage for a rental property for $400k, and the monthly p&amp;i I pay for this ends up being $3500 as an example.

Then, lets say the monthly rent I get from 6 tenants ends up being $6k.

That means the entire Mortgage's monthly p&amp;i is given to me to pay on a consistent, regular basis, and then some.

How is that "riskier" for a lender than, for example, a regular home mortgage where the buyer is dependent on them own personal income to pay for the mortgage?

Thanks
[{"id": "f1igi9w", "text": "Home mortgages are effectively subsidized by the government and owners are less likely to \u201cwalk away\u201d.  Commercial deals are more about the underlying collateral performance.", "replies": [{"id": "f1kqgiv", "text": "this is the correct answer", "replies": [], "depth": 2}, {"id": "f1lalc0", "text": "I would also add that commercial real estate that is owner occupied is treated as less risky as well, and statistically speaking they are less risky.", "replies": [{"id": "f1lgzrp", "text": "These are subsidized too by the SBA. Owner occupied real estate is extremely risky since its not owned by someone in the business of investing in real estate. Business goes belly up so does the loan. Business goes belly up for an investor they evict them and get a new tenant and meanwhile pay the loan with surplus cash flow from other investments. Banks hate owner occupied real estate unless the SBA takes on most of the risk.", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "f1ih6bo", "text": "Commercial spaces can sit vacant for years and reletting them can mean huge tenant improvement allowances.", "replies": [], "depth": 1}, {"id": "f1ijlaq", "text": "From a lender's perspective, the intuition is that a borrower is more likely to prioritize paying their home mortgage before paying the loans on their investments. Furthermore, lenders consider managing commercial real estate more complicated than holding down a W2 job. The primary source of repayment in the case of a commercial loan (cash flow from managing commercial rental property) is higher risk than a residential loan (cash flow from employment).\n\nFrom a borrower's perspective, commercial mortgages often have balloon payments, prepayment premiums, and floating rate aspects that increase the risk of default.", "replies": [{"id": "f1ipg88", "text": "hmm great info thanks and can you explain these three points you made a bit further: balloon payments, prepayment premiums, floating rate aspects.\nThanks", "replies": [{"id": "f1iz9eg", "text": "**Balloon Payment.** Many commercial loans don't fully amortize during the loan term. As such, when the loan matures, the outstanding balance is due. This is called a bullet or balloon payment. I recommend looking for full term loans where the loan fully amortizes during the loan term. This ensures you don't need to come up with cash or refinance the remaining principal during a downturn.\n\n**Prepayment Premiums.** If you decide to refinance or payoff your loan early, you will have to pay a fee if you are within your prepayment premium/penalty window. For hybrid commercial mortgages, the prepayment premium generally lasts for the duration of the fixed rate period. Some agency loans have prepayment premium periods during the adjustable period as well. You can avoid prepayment premiums by getting your loan from a credit union rather than a bank or agency. In any event, I recommend against yield maintenance prepayment premiums and instead going with a step-down prepayment premium structure.\n\n**Floating Rate Aspects.** Many commercial loans have interest rates that change or \"float\" during the loan term. The loan may be fixed for an initial period (say 5-years) and then float thereafter until maturity. This is risky because the rate generally adjusts up, which increases the debt service and increases the risk of default.\n\nThe Freddie Mac Small Balance Program (Optigo) term sheet [here](https://mf.freddiemac.com/docs/product/small_balance_loan.pdf) will give you an idea how apartment loans are typically structured.", "replies": [{"id": "f1jdh5c", "text": "thanks for the excellent info! Do you also know where I should start looking for lender?", "replies": [{"id": "f1jvomr", "text": "Commercial banking is a local game. So no BOA, no Chase. You want to find someone who operates in your state&gt;county&gt;city and your product type.\n\nThe smaller the bank the more they specialize. Meaning they have more favorable rates, fees, and terms for Mulitfamily, Strip Malls, or Office buildings. \n\nThese favorable rates come from volume. Once they've seen an asset type 1000 times. Their 1001 time underwriting a project secure will be easier and lower cost for them. This works out in your favor.", "replies": [{"id": "f1jw2t5", "text": "Also, No balloon payments on your loan. If the market takes a shitter and you can refi or buyout the loan at the end of the term the bank takes your property.\n\nMake sure at the end of the term the rate adjusts to the market. Even if the rate jumps up from 4.5 to 8.5 you still have some breathing room and flexibiilty to find a solution as opposed to, having to come up with the full amount all at once.", "replies": [], "depth": 6}, {"id": "f1k9fow", "text": "interesting stuff thanks so much. And when you say \"state&gt;county&gt;city\" what if I live just outside of Chicago, I'd have more variety if I actually drove into Chicago and looked there for a local bank, right? Even though I technically don't live in \"chicago\" but rather a suburb of chicago.", "replies": [], "depth": 6}], "depth": 5}, {"id": "f1k5wxt", "text": "Depends on the property. If you want to direct message me, I can help you further.", "replies": [], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "f1ikr6u", "text": "It\u2019s not that straight forward and depends on a lot of things, including Borrowers credit. If the commercial loan is non recourse, then the lender only looks to the property for repayment in event of default (ignoring bad boy carveouts situations).\n\nPersonal conventional mortgages are typically sold to bond investors and those payments have a guarantee from the Agencies, effectively making them risk free (based on agency solvency and ultimately a bailout by tax payers if \u201809 happens again). So the Lender has completely shifted the risk off their balance sheet. Plus, as others have said, all things being equal, a Borrower is more like to prioritize payments on their primary residence  over an investment property.\n\nSource: Am a commercial balance sheet lender", "replies": [{"id": "f1ip7mb", "text": "Interesting stuff thank you. So besides the typical 25% down, what potential holdups or pitfalls should I be aware of if I'm hoping to get a commercial mortgage for a rental (5+unit) property? I have excellent credit and already own an unrelated business with zero personal debt and zero business debt?", "replies": [{"id": "f1is24r", "text": "Make sure your PSA and ESA are clean before they go to the lender, or have a plan to deal with whatever they find.\n\nYou may be asked to either personally guarantee the loan, or hold reserves in the bank.\n\nMake sure your underwriting covers the minimum DSCR and stress test it. Figure out how many months you can afford in vacancy before you violate loan covenants.", "replies": [{"id": "f1it4me", "text": "Thanks so much again, also, is there an established lender you know of that I should look at when searching for getting this type of loan? Or should i just google", "replies": [{"id": "f1j9jzk", "text": "We're using my investor's personal bank right now, largely because he's established there and they've been willing to give us really competitive term sheets with limited covenants/bad boy acts since they know he's consistently good for the money. We've also gotten good term sheets from local/regional banks. Wells/BofA/Chase etc haven't even been remotely competitive vs the regional banks.", "replies": [{"id": "f1jdro6", "text": "oh interesting thanks. So what could be the reason for as you say local/regional banks being more competitive than big banks? I don't currently have a relationship with any local banks but I've always wondered", "replies": [{"id": "f1l0pnl", "text": "Big banks target institutional quality customers ($1+ billion AUM, loans that are $20MM to hundreds of millions).\n\nSmaller regional banks and credit unions don\u2019t compete with those massive deals as much and focus on being competitive for smaller $1 million commercial loans.\n\nThey want to grow with you.", "replies": [{"id": "f1lgzuk", "text": "Oh interesting. So when would be the ideal time to speak with a bank, when I find a property or before?", "replies": [{"id": "f1lin3v", "text": "Before is good.  Tell them what types of deals you\u2019re trying to do.  If you\u2019ve done any before, show them what you\u2019ve done.  Give them your financials.  It\u2019ll help them move quickly for you.", "replies": [], "depth": 9}], "depth": 8}], "depth": 7}], "depth": 6}], "depth": 5}, {"id": "f1l0cnl", "text": "Go to all of your local community banks.  They will be the most aggressive.", "replies": [], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "f1ingy2", "text": "some good observations here. I'll just add a few additional insights;\n\nresidential mortgages are often sold on the secondary market. the lender is effectively relieved from any and all risk/liability after this happens, all that moves downstream to the purchaser(s). this was one of the main issues that caused the mortgage crisis back in '08. commercial loans however are typically held by the institution for the life of the loan. we have to hold and manage that risk for years.\n\nalso, its much easier to walk away from a bad investment than the roof over your head. furthermore, there's no real counterpart to consumer credit report for businesses. sure there are business credit reports, but those are pretty worthless since you can organize a new entity in a matter of hours and start with a blank slate if you so desire. can't do that with consumer credit.\n\nspecific to multifamily, which you seem to be focusing on, lender's don't really vet individual tenants (though we often do for commercial tenants). therefore, we don't know how reliable those tenants are, whereas we do a lot of due diligence with granting a residential mortgage.", "replies": [{"id": "f1ipr9b", "text": "Thanks for the great info. So what issues could I run into when looking for a commercial mortgage for a rental (5+unit) property? I have excellent credit, zero business debt, zero personal debt, and already own an unrelated business. Thanks again", "replies": [], "depth": 2}, {"id": "f1jkniz", "text": "&gt;secondary market\n\nThis but I'd add there is still risk but it's being treated differently. Any one home loan for a bank could still be a risk. But the loan is often packed together with a bunch of other loans and investors know it's going to have about a 4% default rate (or whatever the number is), compared with having either 0% or 100% default on any single loan. And I'm guessing they package loans from various markets to distribute the risk of a downturn in any single community having a large impact. It's harder to do a bulk loan for commercial properties because (A) the government isn't involved to make it happen, and (B) the properties vary too much so it's still harder to have a reliable homogeneous product.", "replies": [], "depth": 2}], "depth": 1}, {"id": "f1jd2v3", "text": "The risk in the 4-10 unit space it is that the bank is relying on your ability to operate the property as a business to cover the mortgage, and your area of expertise may not be in property / asset management. On the other hand, when you cover the mortgage on your personal residence you are presumably using wages from your job, which they assume you are proficient at since you are being paid a wage in exchange for your labor. \n\n&amp;#x200B;\n\nBeing able to purchase a $400k investment property does not mean you are qualified, although it is not that difficult. I work in multifamily finance and its arguable that commercial mortgages become less risky once you get into the $10M+ space working with professional owner/operators.", "replies": [{"id": "f1jed19", "text": "oh interesting thanks. So if I have the facts correct, at least here in illinois, a 2-4unit property could be had with a residential mortgage. But unless it's in a hot area, the monthly returns from rent would not be much. For someone with a separate established business and cash but who is just starting out in this field, like myself, is this the path you'd recommend versus larger 5+unit properties?", "replies": [{"id": "f1jffje", "text": "If you had the cash but lack the operating experience it wouldn't be a bad idea to first look into 2-4 unit properties with a residential mortgage. With that being said, don't shy away from multifamily just because you're new. You will more than likely need to contract 3rd party manager but the underlying business fundamentals are not hard to grasp.", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "f1k0nhf", "text": "1. Residential mortgages are backed by the government (Freddie and Fannie in the US, CMHC in Canada). Commercial mortgages are not backed by the government. \n2. Commercial leasing is much more complicated than residential, and vacancies between tenants are measured in the double digits of months or years depending on the property; residential rental vacancies are typically a handful of months. So if a property is being purchased with long term stable or national tenants versus vacant or risky tenants that will make a big difference in the mortgage lender's perceived risk in the deal.", "replies": [], "depth": 1}]