Commercial vs residential home loans

Commercial vs residential home loans feature image 3

Features, rates, fees and credit accessibility are just some of the things that vary between a commercial and a residential investment loan. Find out more about the key differences between the two.

There are fundamental differences between an investment loan that is used to purchase commercial property and a loan that is suited to the purchase of a residential property.

Find out how the structure of these loans differ and what you should keep in mind when tossing up between buying a commercial property and buying a residential property.

Property types

One primary difference between commercial and residential investment mortgages is the property type (that is, whether you are acquiring a business or residential property).

For example, if you take out a commercial loan, you can potentially purchase a business property such as retail space, a child care facility, restaurant, hotel, medical centre, or even a digital billboard (if you want to get creative).

On the other hand, if you’re buying residential property, you are generally limited to purchasing a house, apartment or unit.

Home loan structure

Most commercial property loans are similar to residential investment loans. You can select from a variable, fixed or split rate, and you can also choose between making principal and interest or interest-only repayments. (Most investors prefer interest-only repayments due to the potential tax benefits.)

However, the type of home loan product (and features) that are suited for a commercial or residential purchase are different.

For instance, you may want to consider a line-of-credit commercial home loan or a self-managed super fund (SMSF) home loan for commercial property so you have greater flexibility to access your funds (due to the higher expense of upgrades for commercial real estate compared to residential real estate).

On the other hand, if you have bad credit history or limited savings, you may have a better chance of qualifying for a residential investment loan. You may consider an introductory rate home loan or a low doc home loan depending on your ability to access finance. Based on your strategy, you may need to find an interest-only investment loan with a 100% offset account to reap tax benefits.

Speak to a commercial broker or residential broker about the structure of your home loan.

Loan-to-value ratio (LVR)

Depending on your financial position and the lender’s individual policy, most banks will lend up to 60-70% LVR for a commercial property loan. The amount you can borrow will also depend on the potential rent or yield that can be generated from the property. As a result, you typically need a 30% deposit to gain approval for a commercial home loan. Due to the higher purchasing cost of commercial property, finance for a commercial loan is less accessible compared to a residential investment loan.

However, the LVR is generally higher for residential home loans, with most lenders allowing you to borrow between 90-95% of the property value (depending on your credit history and your serviceability potential). If you are a blue-chip borrower and you can borrow with 90-95% LVR, then you may only need to come up with 5%-10% deposit to qualify.

It’s advised that you complete a 20% deposit for a full documentation loan in order to avoid paying lenders mortgage insurance (LMI).

Interest rate and fees

As a rule of thumb, interest rates may be higher for commercial loans compared to residential home loans due to the inherent risk of commercial loans (such as longer untenanted periods).

To further offset the risk of commercial loans, fees are generally higher for commercial loans than residential loans.

Eligibility criteria

While your ability to qualify for a commercial or residential loan will depend on the lender’s eligibility criteria, banks normally impose stricter criteria for commercial property loans (as reflected in lower loan-to-value ratios and higher interest rates). This is due to the fact that a commercial property may be more difficult to sell in the event that you default on the loan.

As a result, the valuation of a commercial property is more detailed compared to the valuation of a residential property, and you may be required to provide more documentation than you would with a residential investment loan.

Residential vs commercial property

Investing in commercial real estate differs significantly to investing in residential property. While your role as an investor is similar – you rent out the property and receive rental income from the tenant – there are various implications of both residential and commercial property that you should keep in mind.

Rental return

A commercial property generally offers a higher return on investment (ROI) compared to a residential property. Data from CoreLogic (2015) indicates that the average rental yield for a commercial property, such as a warehouse, is around 8%-10%, whereas the return for a residential property, such as a house, averages around 3.5%.

Lease period

The average lease period for a commercial property is 3-10 years (sometimes as long as 15 years) whereas the lease period for a residential tenant may be just 6-12 months with no guarantee of renewal. The difference in lease periods is due to the fact that commercial tenants tend to stay in the property for longer, as they may be more inclined to make improvements to the property.

For instance, a commercial tenant may invest $25,000 to renovate the space for their business, whereas a residential tenant is less likely to invest money in the property (especially if it’s an apartment with strata by-laws).

Untenanted period risk

While untenanted periods are a risk for both commercial and residential properties, this risk is more adverse for commercial property. This is due to the fact that tenants tend to be more hesitant, as they could be locked in for 5-10 years.

Most banks are conservative about lending for commercial properties because the borrower will have to cover expenses during untenanted periods.

Cost of upgrades

Renovating a commercial property such as a retail space or office may be relatively expensive compared to renovating a residential property. This is because upgrades for a commercial property may require a greater scope of work for a larger area and include major tasks such as the removal of asbestos or changing the fit-out.

Upgrades for residential property usually involve smaller and less expensive jobs such as painting or installing new appliances.

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