Some important facts about commercial first mortgage bonds
Creating attractive interest is a challenge in today’s low interest rate environment. The appeal of first mortgage bonds is the fact that the investors (lenders) hold the first position as the owner of the property – so there is a solid asset (real estate) securing their investment.
The 50-year average for home ownership in the United States is about 65%. Most experts see that number declining as the shift to rental communities continues to grow along with the challenges younger consumers face in securing sustainable employment, which is directly related to one’s ability (and willingness) to owns a home. Marketing traditional home mortgage financing in today’s market has created a better understanding of how these loans work for consumers. Couple this with the competition in the home finance market and it’s understandable why most seniors understand home finance. But what about commercial real estate?
Every day consumer leaves their homes and visits multiple outlets – for work – for dining – for shopping – for entertainment – but few understand the differences in the commercial finance market versus the home finance market. The term “commercial loans” is mainly segmented into “multifamily properties (5 plus units), office buildings, retail centers, industrial and warehouse space, single-tenant buildings (such as Lowes and Walmart), and special-use properties such as gas stations, schools, churches, etc. Regardless of the use, access to commercial loans is quite different from a home loan.
With home loans, the normal procedure is for the lender to request 2 years of tax returns, bank statements, payment adjustments, credit check and property appraisal. Lenders’ primary focus is the borrower’s ability (through an income and expense model) to make the monthly mortgage payments, including taxes and insurance.
With a commercial loan, the lender will first look at the condition of the property and its ability to service the loan outside of the cash flow from its day-to-day operations. The lender will ask for copies of current leases (lease note) and two years of the borrowers operating history. They will also review recent capital improvements, interior and exterior photos of the property, and lien and title searches. With these documents in hand, the underwriter will create a debt service coverage ratio (DSCR) to determine if the property can cover the requirements that the new loan will carry with it. In addition, the lender will look at 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 solid financials and a credit history to qualify for the loan. However, the lender gives the most weight to the properties ability to support the loan over that of the borrower’s personal situation. This is in direct comparison to taking out residential mortgages, where the borrower’s personal financial situation is of greater importance than the property that is part of the mortgage.
There are six sources of commercial real estate lending – Portfolio Lenders – Government Agency Lenders – CMBS Lenders – Insurance Companies – SBA Loans – Private/Hard Money Lenders.
Portfolio lenders – they consist primarily of banks, credit unions, and corporations that participate in commercial loans and hold them on their books until the maturity date.
Government Agencies Creditors – these are companies that are authorized to sell commercial loan products that are 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 (length and interest) and payment priorities in the event 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 lending guidelines as other lenders and therefore have more flexibility to create loan packages outside of conventional lending norms.
SBA loans – Borrowers looking to purchase commercial property for their own use (owner occupied) have the option of using an SBA-504 loan, which can be used for a variety of purchases for their own business, including real estate and equipment.
Private money/hard loans – For those borrowers who cannot qualify for traditional financing due to credit history or challenges with the property in question – hard cash loans can be a viable source of funds for their planned project. These loans have higher interest rates and cost of money compared to other types of loans. Despite higher borrowing costs, these loans meet the needs of the commercial mortgage market.
Commercial mortgage loans can be either recourse or non-recourse in design. In a typical recourse loan, the borrower(s) are personally liable for the loan in the event that the loan is foreclosed and the proceeds are insufficient 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 nonrecourse loans, a provision called a “bad boy clause” is part of the loan documents, which states that in the event of fraud, willful misrepresentation, gross negligence, criminal acts, misuse of property income, and unexpected insurance proceeds, the lender may hold the borrower(s) personally liable for the mortgage debt.
It is understandable that when negotiating a commercial mortgage, lenders prefer recourse loans, while borrowers would prefer non-recourse loans. In the signing process, the lender and borrower(s) work to create a loan that meets the needs and goals of both parties, and if an impasse occurs, the loan is not made.
The world of commercial mortgages offers investors the opportunity to participate in a market that can have attractive yields, underlying security through lien positions on real estate assets, and durations (12 months to 5 years) that are acceptable to most. Creating ongoing monthly interest through holdings such as commercial mortgage bonds is attractive to both consumers and institutional investors.
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