Creating attractive interest is challenging in today’s low interest rate environment. The appeal of first position mortgage notes lies in the fact that investors (lenders) remain in first position as holders of the property, so there is a tangible asset (real estate) providing the security of their investment.
The 50-year average for home ownership in the United States is around 65%. Most experts see that number dwindling as the movement into rental communities continues to increase along with the challenges younger consumers encounter in securing sustainable employment that is directly tied to ability (and desire) of owning a house. The commercialization of traditional residential mortgage financing in today’s market has created a greater understanding of how these loans work for consumers. Combine that with the competition in the residential financing market and it’s understandable why most adults understand residential financing. But what about commercial real estate?
Each and every consumer leaves their homes and visits multiple commercial properties – for work – to eat – to shop – for entertainment – but few understand the differences in the commercial financing market versus the residential financing market. The term “commercial loans” is primarily segmented into “multi-family properties (5+ units), office buildings, shopping malls, industrial and storage space, single-tenant box buildings (such as Lowes and Walmart) and single-use properties.” such as gas stations, schools, churches, etc. Regardless of use, access to business loans is quite different from residential loans.
On 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. Loan underwriters’ primary focus is the borrower’s ability (through an income and expense model) to make monthly mortgage payments, including taxes and insurance.
On a commercial loan, the lender will first look at the condition of the property and your ability to repay the loan out of cash flow from your day-to-day operations. The lender will request copies of current leases (rent list) and two years of borrowers operational history. 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 meet the demands that the new loan will bring. Additionally, the lender will look at third-party appraisals paying attention not only to the property in question, but also the surrounding area and trends in the market.
A business borrower must have a strong credit and financial history to qualify for the loan. However, the lender places the greatest weight on the property’s ability to sustain the loan over the personal situation of the borrower. This is in direct comparison to residential mortgage underwriting where the personal financial situation of the borrower is more important than the property that is part of the mortgage.
There are six sources for commercial real estate loans – Portfolio Lenders – Government Agency Lenders – CMBS Lenders – Insurance Companies – SBA Loans – Private Money/Hard Money Lenders.
portfolio lenders – These are primarily made up of banks, credit unions, and corporations that engage in business loans and keep them on their books until the maturity date.
Government Agency Lenders – These are companies that are licensed to sell commercial loan products funded by government agencies like Freddie Mac and Fannie Mae. These loans are pooled (securitization) and sold to investors.
CMBS Lenders – these lenders issue loans called “CMBS Loans”. Once sold, the mortgages are transferred to a trust that, 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 looked to the commercial mortgage market to increase the yield 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 credit 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 those borrowers who cannot qualify for traditional financing due to credit history or problems with the property in question, hard money loans can be a viable source of funds for the intended project. These loans have higher interest rates and costs of money than other types of loans. Regardless of the higher borrowing costs, these loans fill a need in the commercial mortgage market.
The Commercial Mortgage Loans can be with recourse or without recourse in their design. In a typical recourse loan, the borrower(s) are personally responsible for the loan in the event that the mortgage is foreclosed and the income is not enough to pay the loan balance in full. In non-recourse loans, the property is the guarantee 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 states that in the event of fraud, willful misrepresentation, gross negligence, criminal acts, misappropriation of property proceeds and profits unexpected insurance, the lender may hold the borrower personally responsible for the mortgage debt.
Understandably, in commercial mortgage negotiations, lenders prefer recourse loans when borrowers would prefer non-recourse loans. In the underwriting process, the lender and borrower(s) work to create a loan that meets the needs and goals of both parties, and if deadlock occurs, the loan is not issued.
The world of commercial mortgages offers investors the chance to participate in a market that can have attractive yields, primary security through real estate bond positions, and durations (12 months to 5 years) acceptable to most. Building ongoing monthly interest through holdings like Commercial Mortgage Notes is attractive to both consumers and institutional investors.