Many small-scale developers have used a residential loan for their project, but fewer have sought commercial finance. Residential and commercial loans differ greatly in their valuation and approval processes, as well as the final apparent cost of funds to borrowers.

It’s important that small-scale developers know the difference between residential and commercial loans. Daniel He, property director at specialist development lender CrowdProperty, outlines the fundamental differences for small-scale property developers.

Valuations

Residential valuations are very simple and often take just a few days to finish, while commercial valuations are more complex, requiring several weeks or even months to complete.

Residential valuations simply involve comparing a given property to other properties in the same vicinity with similar location, land size, and build that have recently sold, before determining a likely price on that basis.

Commercial valuations are far more involved, calculating the value of a property using reverse feasibility analysis — in essence, an estimation of what developers are likely to pay based on a target sales price. This usually includes other assumptions, such as developer profit, interest rate, and time to complete the project, adding complexity to the value of the land.

What can be funded

Commercial loans allow borrowers to use the funds for a much broader range of purposes than residential loans.

Residential loans in construction finance loans generally only cover the funding of land and construction costs — and that’s pretty much it.

Commercial loans in construction finance cover land and construction costs as well as soft costs, which include a range of costs associated with bringing a development to life, such as architects fees, engineers fees, council contributions, and even closing costs.

For residential loans, the LVR is typically based on the total development cost (TDC). In contrast, commercial loans use the gross realisation value (GRV) as the basis for their LVR calculations.

Serviceability and approval

With residential loans, banks typically look at your ability to service a loan — how much income you bring in through your day job and any other sources of income, like rent from investment properties.

With commercial loans, it’s about how well your project stacks up. Banks want to know if it’s a profitable project for the risk you’re taking on, and whether you’re the right person with the right team to deliver the project.

As such, the documents required when applying for a residential loan are vastly different from those required to apply for a commercial loan.

Interest payments

Residential loans are generally variable interest and paid on a monthly basis. This means loans taken out six months ago can all of a sudden be three percentage points higher if interest rates rise. The monthly interest service can also cause pain for borrowers.

Commercial loans are generally fixed interest, but also capitalised with fees included, meaning bundled into the loan amount you repay at the end. This puts more money back into the pockets of borrowers, helping them to retain working funds.

Pre-sales and debt coverage

Banks will ask for debt coverage when making residential loans. For example, if the loan is $1 million and banks require debt coverage of 100%, this means pre-sales of your project need to be $1 million.

Debt coverage can cause delays to projects, as banks will only provide residential loans once pre-sales are sufficient. Depending on the market environment, these pre-sales can take up to several months.

In contrast, many commercial lenders don’t usually require pre-sales, so borrowers can start their projects right away once they obtain their development application (DA) approval and construction certificates. This can save months of time prior to the start of construction. Developers can start building sooner and exit projects earlier, enabling them to save money on interest and maximise project profitability.

CrowdProperty provides property project finance for property professionals with speed, ease, and certainty. Find out more about commercial loans for small-scale property developers.