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Investors looking to purchase real estate quickly learn that the market is divided into two distinct markets: commercial and residential. The residential market is composed of properties that are mainly primary or secondary residences and are generally not purchased for the purpose of generating income. Most residential properties are purchased because buyers fall in love with the property they will be calling home. Commercial properties are purchased based on financial calculations such as cap rate, cash flow, and cash-on-cash return, and revenues it will potentially earn for the owner. Emotion is not a criterion in the purchase of a commercial property.
The requirements for purchasing residential real estate are much less stringent than the requirements for purchasing commercial real estate. Residential real estate purchases are based on the buyer's personal credit scores and their debt-to-income ratio (DTI). Lenders will lend to buyers if their DTI is below a certain percentage which is usually 45 percent or less. Buyers who have lower credit scores can still obtain financing if they have a larger down payment. Once the buyer meets the lender's requirements s/he will qualify for financing and purchase the residential property.
The purchase of commercial property is a more complex transaction. Most commercial properties are purchased with non-recourse loans which means, if the buyer fails to make payments, the lender is not able to pursue the buyer personally in collection of the monies owed. For this reason credit scores and DTI are not criteria used in the purchase of commercial properties. Instead lending on commercial properties is based on the potential cash flow, cap rate, and net operating income (NOI) generated by the property.
Sales of residential properties can occur in as little as a few hours, but the average time to close is approximately a month. Commercial properties can easily take a few months to over a year to close. For this reason commercial real estate agents earn a higher commission on each sale as compared to the sale of residential properties. Commercial real estate agents may sell a tenth of the number of properties as compared to sales of a residential agent but can end up with an annual income more than twice the amount.
Lenders have no problem with lending to first-time investors for the purchase of a residential property as long as the lending requirements are met. Whereas first-time investors will have difficulty buying a commercial property as lenders are reticent to lend to someone with no experience. Generally commercial loans require one of the primary applicants to have experience dealing with the type of property being purchased. This requirement shuts the door on newer investors.
The potential profit from a commercial property sale is much greater than a sale on residential property. The old adage of higher risks potentially bringing higher rewards is the driving principle behind this reality. Most investors begin their careers investing in residential real estate and then move into commercial real estate after several years of successful investing.
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