Creating attractive interest is challenging in today’s low interest rate environment. The appeal of prime mortgage notes lies in the fact that investors (lenders) remain in the top position as property lien holders, so there is one hard asset (real estate) that provides the security of your investment.
The 50-year average for homeownership in the United States is approximately 65%. Most experts see the number shrink as the move toward rental communities continues to grow along with the challenges that younger consumers encounter in securing sustainable employment that directly correlates with ability (and desire) of owning a house. The commercialization of traditional residential mortgage financing in today’s market has created a better understanding of how these loans work for consumers. Combine that with the competition in the home finance market and it’s understandable why most adults understand home finance. But what about commercial real estate?
Each and every consumer leaves their homes and visits multiple commercial properties – for work – for dinner – for shopping – for entertainment – but few understand the differences in the commercial financing market versus the residential financing market. The term “business loans” is primarily segmented into “multi-family properties (more than 5 units), office buildings, shopping malls, warehouse and industrial space, individual tenant box buildings (such as Lowes and Walmart) and specialized use properties such as gas stations, schools, churches, etc. Regardless of use, access to commercial loans is very different from residential loans.
In residential loans, the normal procedure is for the lender to request 2 years of tax returns, bank statements, pay stubs, 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 examine the condition of the property and its ability to repay the loan from the cash flow of its daily operations. The lender will request copies of the current leases (rental roll) and two years of the borrower’s operating history. In addition, they will review recent capital improvements, internal and external property photos, and lien and title searches. With these documents in hand, the insurer will create a debt-to-service coverage ratio (DSCR) to determine if the property can meet the demands that the new loan will entail. In addition, the lender will analyze third party evaluations paying attention not only to the property in question, but also to the surrounding area and trends in the market.
A commercial borrower needs to have a solid financial and credit history to qualify for the loan. However, the lender attaches the greatest importance to the ability of the properties to maintain the loan over the personal situation of the borrower. This is in direct comparison to underwriting of residential mortgages where the personal financial situation of the borrower is a greater concern than the property that is part of the mortgage.
There are six sources of commercial real estate loans: portfolio lenders, government agency lenders, CMBS lenders, insurance companies, SBA loans, private money / hard money lenders.
Portfolio Lenders – These are mainly made up of banks, credit unions and corporations that participate in commercial loans and keep them on their books until the maturity date.
Government agency lenders – These are companies authorized to sell commercial loan products financed by government agencies such as Freddie Mac and Fannie Mae. These loans are pooled (securitized) and sold to investors.
CMBS Lenders – These lenders issue loans called “CMBS loans”. Once sold, the mortgages are transferred to a trust, which in turn issues a series of bonds with different terms (duration and rate) and payment priorities in case of default.
Insurance companies – Many insurance companies have turned to the commercial mortgage market to increase the yield on their holdings. These companies are not subject to the same regulatory loan guidelines as other lenders, and therefore have more flexibility in creating loan packages outside of conventional loan rules.
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 the business itself, including real estate and equipment.
Private money / hard money loans – For those borrowers who cannot qualify for traditional financing due to credit history or challenges with the property in question, hard money loans can be a viable source of funds for your intended project. These loans have higher interest rates and money costs than other types of loans. Regardless of higher loan costs, these loans fill a need in the commercial mortgage market.
Commercial mortgage loans can be with or without recourse in design. In a typical resource loan, the borrower (s) is personally responsible for the loan in the event that the loan is executed and the income is not sufficient to pay the full balance of the loan. In non-recourse loans, the property is the collateral and the borrower is not personally responsible for the mortgage debt. In typical non-recourse loans, a provision called “bad boy clauses” is part of the loan documents that state that in the event of fraud, intentional misrepresentation, gross negligence, criminal acts, misappropriation of property income and profits In unexpected insurance, the lender can personally hold borrowers 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 the borrower (s) work to create a loan that meets the needs and goals of both parties, and if a deadlock occurs, the loan is not issued.
The world of commercial mortgages offers investors the ability to participate in a market that can have attractive returns, prime security through real estate asset lien positions and durations (12 months to 5 years) that are acceptable to most. The creation of continuous monthly interest through participations such as Commercial Mortgage Notes is attractive to both consumers and institutional investors.