As an investor, you know how crucial it is to diversify your holdings to protect yourself from market shocks. Owning a variety of stocks and cryptocurrency is vital, but delving into real properties can provide you with further security.
If you’ve cut your teeth on crypto and better understand the risks and rewards of investments, consider kicking it up a notch by exploring the world of commercial real estate. This option comes with its own unique loan options, including Debt Service Coverage Ratio (DSCR) mortgages, as well as particular challenges that you must be aware of. Today, we’ll briefly overview both the benefits of commercial real estate and your options for financing your new purchase.
Why Purchase Commercial Real Estate?
Real estate is one of the most secure assets you can have because it appreciates over time; this is part of why home ownership is considered a significant element of the American Dream. However, commercial real estate doesn’t just offer you a payoff down the future: it also affords you an excellent income for as long as you own the property. The average return on investment for commercial real estate is about 10%, as opposed to the S&P, which has an average annual ROI of 7.2%, making it the obvious superior choice.
What Are DSCR Loans?
Once you’re ready to look into commercial real estate, you need to consider how you will fund this purchase. One option is Debt Service Coverage Ratio (DSCR) loans, which rely on a ratio of profit to debt to determine whether a property is viable.
To determine whether a given property should be approved for a loan, a lender will take the expected rent from the building and then divide that by the debt service: principal, interest, taxes, insurance, and association fees. This will give a ratio that shows how well the property can cover its debt. Anything below 1 means the property is losing money; a ratio of 1 means you’re breaking even, and a ratio above 1 means you are making a profit. Typically, lenders want a ratio of 1.25 or higher, meaning that your property is making 1.25 times what it costs to cover its debts.
Benefits of DSCR Loans
While you can use conventional mortgages, those are more geared toward residential homes and require a lengthy paperwork process. Because DSCR loans are almost entirely focused on the aforementioned ratio, you can get a DSCR loan in Pennsylvania, or any other state, incredibly quickly: all the lenders need about your personal finances is your credit score. You don’t need to provide tax returns, pay stubs, or debt-to-income ratio to qualify; instead, you’ll provide a tenant history that shows the expected rent and a property appraisal.
As with other loans, you must provide a down payment and cover closing costs. The down payment is typically a bit higher than for residential loans: most lenders would like at least 20%, but you may need to provide more based on your credit score.
Important Considerations When Delving Into Commercial Real Estate
Commercial real estate is an excellent opportunity to build a steady income and develop equity you can leverage later, but it also has some significant caveats.
As with any business decision, you must pay taxes on your earnings. This can get complicated if you have multiple properties, so you may find it helpful to work with a financial advisor or tax preparation company that can assist you in navigating the world of corporate taxes. Fortunately, many states have excellent tax breaks for commercial real estate, which your advisor will walk you through.
Interest rates for commercial loans, including DSCR loans, are higher than for residential loans because they are riskier. These loans are not secured by the government, meaning they cannot be packaged and resold by Fannie Mae and Freddie Mac; in other words, if you default, the lender would be out a significant amount of money. This is also the reason that you will often have to pay a prepayment penalty if you choose to pay ahead on your DSCR loan. Typically, this will be a certain percentage of the principal for the first five years, often on a “step down” basis. For example, if you paid off your mortgage in the first year of the mortgage, you would have to pay 5% of the principal in addition to the overall payment and interest.
Commercial real estate is an excellent opportunity, but it has its tradeoffs. However, working with a reputable DSCR lender can allow you to build your portfolio quickly and develop a reliable source of income from your investments. As one of the oldest and most reliable investment methods, commercial real estate is the natural next step for those who have already gotten a taste of the exciting world of investing through cryptocurrency and stocks.