Difference Between Residential and Commercial Financing

Peter Kinch explains the difference between residential and commercial financing

Call it Commercial Financing 101. I received a call from a client recently who had just put an offer in on a property and needed a mortgage. They had purchased a four-plex only a few months earlier and wanted to know if they could get the same discounted rate for this purchase.

Normally I'd say, no problem, but upon further examination of their deal, I discovered that the property they were buying was an "eight-plex." What's the big deal you might ask? Well, the problem is that the purchase of the four-plex fell under the definition of "residential" financing, whereas an eight-plex is considered a 'commercial mortgage' and the difference between financing the two is quite significant. This simple misunderstanding is probably one of the most common misconceptions in mortgage financing. Many investors do not realize that there is a major difference between residential and commercial financing and as such, enter into purchase agreements with false expectations and often end up disappointed and frustrated.

Different sandbox = different rules

The frustrating part for most borrowers is a misinterpretation of the definition of 'commercial.' Many investors assume that a commercial property is one that includes a retail unit or business component in the building. The problem is that the definition of 'commercial' can vary depending on who you're asking - your Realtor, your banker or your accountant. For our purposes, we are interested in the banker's definition. From a mortgage perspective, a property may be deemed to be commercial as soon as you get beyond a four-plex. Again, we have to realize that we're in a new sandbox. Not only have the rules changed, but so too have the players. Many of the lenders who are happy to lend in the residential sandbox, have opted out of this 'sandbox' completely, whereas some new players have now entered the fray.

Clear definitions

First off, let's define when a mortgage is deemed to be commercial versus residential.

A single unit, duplex or triplex will always be considered a residential property for mortgage purposes. Virtually every bank will treat a four-plex as a residential mortgage as well, however, this is the cut-off point for some lenders and they may only choose to do a four-plex as a residential mortgage on an exception basis (i.e., application must be strong).

A "five-plex" is completely in the grey-zone - most residential lenders opt out at this point and your broker will have to do some digging to find a lender who will treat this as residential.

A "six-plex" is where 99% of the 'residential' players now opt out. Your broker will be extremely limited in finding a lender who will look at this as a residential deal. There is one lender in Canada who is currently treating up to eight units in a multi-family complex as residential, but they are only doing so in Ontario at this point. Beyond that, you will definitely be dealing in the commercial sandbox. The other obvious clue that makes property residential versus commercial is the zoning. Quite often this comes to light when the broker or banker receives the appraisal.

(*Note: Don't confuse an eight-plex, which has eight separate suites, each having its own entrance and each being fully self-contained, with a residential house that has eight rooms rented out and a hot plate in each room for cooking. The latter is considered a 'rooming house' and the banks will scatter quickly if they read this in an appraisal. Simply put - they don't like them. So if you're buying one, expect even more problems. The same is true for 'student housing,' so again, proceed with caution.)

So what's the big deal?

What difference does it make if a property is considered commercial or residential?

First of all, the entire underwriting process now changes - as you might have guessed, new sandbox, new rules. The simple explanation is that in the residential sandbox, you the borrower, were the main focus and the property was secondary. In the commercial box, the property becomes the focal point and you (the covenant) become secondary - which may come as welcome news for some.

The biggest difference between the two is the cost of doing business. In the residential sandbox, the interest rate was very predictable, there was no lender fee, the appraisal costs were low and the legal fees were standard. All of those change when you buy a multi-family/commercial property. The rates could be higher; the bank charges a fee - as does your broker, the appraisal costs start at $1,200 and can go much higher. The legal and accounting fees will be higher. Your residential home inspector is not the same person you will use for a commercial property inspection (and yes, you guessed it, they don't charge the same) and lastly, the lender will likely ask for a Phase 1 Environmental on the property. Other than that, there's no difference.

Source: Peter Kinch, Mortgage Expert