What’s the difference between commercial and residential mortgages?

Protecting Your Property: LLC or Not for Commercial and Residential Mortgages?

LLC or not?  There’s a parade of gurus and booksellers urging us constantly to form trusts, LLCs, offshore partnerships and pay them for their kits to do it. All of these have their place, but the easiest way to achieve our protection goals is to hold all rental property in one or more LLCs.

It sounds cheap and easy, but as with many other critical factors in real estate, the question is TIMING!

When is the right time to quitclaim our property into an LLC?

The answer to this critical question has to do with how banks lend to investors. There are generally two types of purchase money mortgage loans written in today’s markets:

1. Residential conforming loans

• Lowest interest rates available (currently about 4.5-5%)
• 30 year terms
• Fixed interest rate for entire term of loan
• 3.5%-20% down
• Lender will generally only write these loans for an investor purchasing property in their personal name
• Limit 10 per person

2. Commercial loans

• Higher interest rates (the lowest I’ve seen lately is 5.5%)
• Usually 20-25 year terms
• Sometimes a bank will offer a fixed rate, but most are 5/1 ARM (adjustable rate)
• Lender has the flexibility to write a loan in the name of any entity, including an LLC
• Usually 25% down or more

Usually the lender has plans to sell off residential loans into the residential secondary mortgage market (hence why they are “conforming” to the standards of the market). In contrast, the lender usually plans to hold a commercial loan in its own investment portfolio for the term of the loan. So usually you’ll only see smaller banks writing commercial loans – my first one came from a bank who primarily lent to the Amish!

Purchase agreement.

Whose name is going on the purchase and sale agreement – your own, or your LLC’s? The answer is whether you want to end up with a residential conforming loan or a commercial loan. Since the residential conforming loan offers favorable terms, we definitely want to use all of these loans for our ten most expensive properties.

The due on sale clause.

Many investors will buy in their own name with a residential conforming mortgage and then quitclaim the property into their LLC’s name. It is a widespread practice. A note about this: it’s not without risk. Every residential conforming mortgage has a due on sale clause which gives the lender the right to foreclose if title has transferred. Quitclaiming a property from one’s personal name to an LLC triggers this clause, but the lender doesn’t have to do anything. 

In this market, most banks are happy to have a performing loan at all, so they likely aren’t going to foreclose simply because an investor quitclaimed the property into a wholly-owned LLC. In the event that interest rates double, however, it’s possible that banks might go hunting for defaults on low-interest fixed loans — and you might be forced to refinance. At this time, it’s a non-issue, but it’s always something to keep in mind.

Cash out refinancing.

One strategy is to buy with cash or a commercial loan and then later refinance into a residential conforming loan, pulling cash out of that property. This strategy works best when buying a house that needs substantial rehab. The problem you’ll run into here is seasoning. A lender is going to require you to hold a property in your personal name for 6 to 12 months before refinancing.

This means that you can’t simply deed the property from your LLC’s name to your personal name the day before closing the refi. (Sometimes banks will write a HELOC without a seasoning period – more on this in a future post). So in order to execute this strategy properly, you’ll have to have some idea as to what your plans are in 12 months.

Portfolio loans.

Once you hold more than 5-10 properties, you’ll want to find a commercial lender who is able to combine multiple properties onto a single mortgage. The seasoning period will likely still apply, and commercial loan terms will apply, but potentially you can seek financing for an unlimited number of properties based solely on their valuation and cashflow.

Wrapping up.

Try your best to find a bank that will write commercial loans for your properties, even if you don’t plan to get one right now. It’s useful for planning purposes to have a contact at that bank to pick his or her brain about the requirements. And as always, have a 12-month plan in mind!