When lenders accept a mortgage loan application for a residential property there is in effect two separate loan approvals – one for the borrower and one for the property. The borrower must be able to show sufficient income to handle not just current debt but also the new debt taken when the mortgage loan is in place. The borrower must be able to demonstrate a good credit history as the lender will review a credit report along with current credit scores. The lender will also make certain the borrower has sufficient cash to close on a transaction and does so by reviewing recent bank and investment statements from the accounts the borrower will use for cash to close.
Separately, the property is reviewed and approved. Since the property is in essence the lender’s collateral, the marketability of the property must be confirmed as well as the overall condition of the home. Marketability is determined by validating recent sales in the area of similar properties. If someone is buying a single family home the lender wants to see at least three recent sales of homes in the neighborhood. If the home is a condominium, the lender wants to see at least three condominium sales in the same project if possible. If not in the same project then a condo in a project nearby. Properties must be similar in nature and a single family home cannot be used as a comparable sale with a condominium loan and vice versa.
Yet a mixed-use property presents some additional challenges when searching for competitive financing and recent changes with FHA loans make financing a mixed-use property much easier and more competitive compared with a traditional commercial loan.
Mixed-Use Property Defined
What is the definition of a mixed-use property? A mixed-use property is one that combines both residential and commercial elements in the same structure. Such property types are more common in urban areas and are relatively easy to identify. One of the more common aspects of a mixed-use property is a building with commercial space on the first floor with residential space above. Most often such a property has multiple residential units either as an apartment building or single family dwellings as a condominium.
If most of the property is primarily commercial then residential loans won’t work. Lenders make such a determination by comparing the square footage of the space reserved for commercial with the amount of space dedicated to residential. This commercial-to-residential ratio is used when borrowers are reviewing available financing options for a mixed-use property.
The difference between a residential loan and a commercial one is twofold- interest rates for commercial properties are higher compared to a residential loan and they are typically of a shorter term. Residential loans offer fixed rates with terms up to 30 years while commercial loans can have variable rates with a balloon payment attached at the end of say seven or 10 years. Commercial loan terms can vary greatly from one bank to the next.
Financing Options for Mixed-Use Property
The two conventional loan types that make up the majority of all residential loans made today are those underwritten to Fannie Mae and Freddie Mac guidelines. Fannie and Freddie both allow for mixed-use properties but under certain provisions. The maximum amount of space dedicated to commercial square footage is 25% of the total amount. This was a relatively recent change when the square footage only allowed for 20% of the total area to be commercial. The vast majority of Fannie and Freddie’s business is single family residential properties and they limit what is considered residential and commercial.
Other requirements when financing mixed-used property with a conventional loan require the structure to be a single-unit dwelling that the borrower also occupies the residential space as a principal residence and must own and operate the business located in the property and should primarily be residential in nature.
They both also rely on a property appraisal that justifies the sales price of a home or the market value of the property in the instance of a refinance. If someone is buying a mixed-use property one of the main tasks of the appraiser is to measure the square footage of the subject property and then arrive at the final ratio. A simple example is a 10,000 square foot building. On the first floor are five businesses with 5,000 square feet total and exceeds the 25% square footage allowance and the buyer must turn to commercial financing. If the commercial space consisted of 2,500 square feet, the property could be eligible. Yet the appraiser must also find other recent sales of mixed-use properties in the area that are similar in nature.
The appraisal report should have a detailed description of the property as well as indicate in the report the property is legal and conforms to local zoning as well as making a comment the operating business in the property doesn’t adversely affect the value or marketability of the property. The appraisal must clearly state the property is appraised as a residential and not a commercial structure.
The FHA Option
Recent changes to FHA guidelines have greatly enhanced residential financing options for borrowers by adjusting the maximum square footage allowed for commercial use. Today, FHA loans can be used to finance a mixed-use property where the commercial space adds up to 49% of the total area as long as the property carries the proper permits and conforms to local zoning statutes. The previous limit was 25%.
A common example of such a structure might be a two or three story building with a café, a furniture store and a salon occupying the first floor and residential space on the second floor. The appraiser is given the sales contract and reviews recent sales of similar mixed-use properties in the area as well as addressing the square footage requirement. If the commercial space is in fact at or below 49% of the habitable area- a parking garage does not count- the property may be FHA eligible given sufficient comparable sales of similar properties and the buyer will occupy part or all of the space as a primary residence.
Remember, FHA loans are only for owner-occupied property and not used to finance a rental. In addition, if the buyer does not have any experience as a landlord prior to this purchase the income from the commercial space cannot be used for qualifying.
Using an FHA loan to finance a mixed-use property isn’t the most common financing scenarios by any means but the changes for allowable commercial from 25% to 49% at least provide more options for buyers while still providing some very competitive financing.
If this is you, you’ll want to speak with a loan officer who can walk you through all the qualifying guidelines before you get too much further into the process. If you’ve got a property picked out and are searching for financing, if the FHA loan fits, it’s probably your best choice.
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