Official Carleton H. Sheets^® Website

I'm sure you've been reading more and more about how the commercial real estate market is following in the footsteps of the residential real estate market. And perhaps you've been wondering how these markets are different. Well, let me explain.

First of all, both markets suffer as bad mortgages, the credit crunch, and plummeting values affect homeowners and residential and commercial investors.

The dividing line between the two markets is determined by units ... residential real estate loans cover single-family homes and small multifamily properties up to 4 units, and a loan on anything over 4 units requires a commercial loan.

And since a commercial property isn't the primary residence of the owner, commercial loans are considered a higher risk loan for banks---and have a higher interest rate than residential loans do. Commercial loans are also appraised differently ... instead of being appraised by the fair market value, commercial properties are appraised using the income approach where the property's value is primarily determined by how much income it produces.

Qualifying for a commercial loan is also different. Many lenders will only loan 70-80% of the value of the property and, although they look at your payment history, they'll generally rely on the income potential of the property when qualifying the loan---unlike a residential loan where your payment history and credit score is of primary concern.

Furthermore, residential real estate loans are often amortized over 30 years---frequently without a balloon clause, while commercial loans are amortized 20-25 years and almost always contain a 3 to 5-year balloon---which requires refinancing the loan when the balloon payment comes due.

Currently, vacancies are prevalent and prices are falling in the commercial real estate market. And if the commercial property's value has fallen far below its mortgaged amount, the bank may not be willing to refinance the entire outstanding mortgage when the balloon payment is due.

So, let's say you own a three-unit commercial property worth $1,000,000, and all of your long-term tenants either moved out or went out of business due to the economic downturn. You bought the property at the end of 2005 when the market was near the top so you have very little equity in property, have a negative cash flow, and the balloon mortgage is due.

What do you do? The property value has dropped and you have no income-producing tenants. You try to refinance but are turned away either due to tight credit restrictions or because the bank requires you to bring a significant amount of cash to closing. In a residential situation, many owners can sell short, do a loan modification, or just weather the storm and hope for a price recovery within the next 5 years or so. But in a commercial situation, many owners are simply walking away.

Do you know of cases like this? Can you think of another alternative for these owners?