Creating attractive interest rates is a challenge in today’s low interest rate environment. The appeal of first position mortgage notes is that the investors (lenders) are held in first position as the lien holder on the property – so there is a durable asset (real estate) providing security for their investment.
The 50-year average for homeownership in the United States is about 65%. Most experts see that number shrinking as the move into rental communities continues to grow with the challenges young consumers face finding sustainable employment that directly correlates to the ability (and desire) to own a home. . The commercialization of traditional residential mortgage financing in today’s market has created a better understanding of how these loans work for consumers. Add to that the competition in the home financing market and it’s easy to see why most adults understand home financing. But what about commercial real estate?
Every day, consumers leave their homes and visit multiple commercial properties – for work – to eat – to shop – for entertainment – but few understand the differences between the commercial finance market and the residential finance market. The term “commercial loans” is primarily segmented into “multi-family properties (more than 5 units), office properties, shopping malls, industrial and warehouse spaces, single-tenant properties (such as Lowes and Walmart), and specialty-use properties such as gas stations, schools, churches, etc. Whatever the use, access to commercial loans is quite different from residential borrowing.
In the case of a residential loan, the normal procedure is for the lender to request 2 years of tax returns, bank statements, payslips, credit check and property appraisal. The primary focus of loan underwriters is the borrower’s ability (through an income and expense model) to make monthly mortgage payments, including taxes and insurance.
In a commercial loan, the lender will first look at the condition of the property and its ability to repay the loan from the cash flow from its day-to-day operations. The lender will request copies of current leases (rent roll) and two years of operating history from borrowers. In addition, they will review recent capital improvements, internal and external photos of the property, and lien and title searches. With these documents in hand, the underwriter will create a Debt to Service Coverage Ratio (DSCR) to determine if the property can cover the demands that the new loan will bring. Additionally, the lender will review third-party appraisals, paying attention not only to the property in question, but also to the surrounding area and market trends.
A commercial borrower must have a strong financial and credit history to qualify for the loan. However, the lender places the most importance on the ability of the property to sustain the loan rather than the personal circumstances of the borrower. This is in direct comparison to taking out residential mortgages where the borrower’s personal financial situation is more of a concern than the property that is part of the mortgage.
There are six sources of commercial real estate borrowing – portfolio lenders – government agency lenders – CMBS lenders – insurance companies – SBA loans – private money/hard money lenders.
Portfolio lenders – these are mainly banks, credit unions and corporations that participate in commercial loans and hold them on their books until the maturity date.
Government agency lenders – these are companies licensed to sell commercial loan products funded by government agencies such as Freddie Mac and Fannie Mae. These loans are pooled (securitized) and sold to investors.
CMBS lenders – these lenders issue so-called “CMBS Loans”. Once sold, the mortgages are transferred to a trust which in turn issues a series of bonds with varying terms (term and rate) and payment priorities in the event of default.
Insurance companies – many insurance companies have turned to the commercial mortgage market to increase the return on their holdings. These companies are not subject to the same regulatory lending guidelines as other lenders and therefore have more flexibility to create loan packages outside of conventional lending standards.
SBA Loans – Borrowers looking to purchase commercial property for their own use (owner-occupied) have the option of using an SBA-504 loan that can be used for various types of purchases for their own business, including real estate and equipment.
Private Money/Hard Money Loans – For borrowers who cannot qualify for traditional financing due to credit history or issues with the property in question, hard money loans can be a viable source of financing for the project they are considering . These loans have higher interest rates and cost of money than other types of loans. Regardless of higher borrowing costs, these loans fill a need in the commercial mortgage market.
Commercial mortgages can be either recourse or non-recourse in design. In a typical recourse loan, the borrower or borrowers are personally liable for the loan in the event that the loan is foreclosed and the proceeds are not sufficient to fully repay the loan balance. In non-recourse loans, the property is collateral and the borrower is not personally liable for the mortgage debt. In typical non-recourse loans, a provision called “bad boy clauses” is part of the loan documents which state that in cases of fraud, intentional misrepresentation, gross negligence, criminal acts, misappropriation of property and windfall insurance, the lender may hold the borrower(s) personally liable for the mortgage debt.
Understandably, in commercial mortgage negotiations, lenders prefer recourse loans where borrowers would prefer non-recourse loans. In the underwriting process, the lender and borrowers strive to create a loan that meets the needs and objectives of both parties and if a deadlock arises, the loan is not issued.
The world of commercial mortgages offers investors the opportunity to participate in a market that can have attractive yields, principal security through preferred positions in real estate assets, and terms (12 months to 5 years) acceptable to most. The creation of continuous monthly interest through assets such as commercial mortgage notes is attractive to consumers and institutional investors.