A commercial mortgage is similar to a residential mortgage, except the collateral is a commercial building or other business real estate, not residential property. In addition, commercial mortgages are typically taken on by businesses instead of individual borrowers. The borrower may be a partnership, incorporated business, or limited company, so assessment of the creditworthiness of the business can be more complicated than is the case with residential mortgages.
Some commercial mortgages are nonrecourse, that is, that in the event of default in repayment, the creditor can only seize the collateral, but has no further claim against the borrower for any remaining deficiency. The general reason for this is twofold: many laws significantly prevent the creditor from going after the borrower for any deficiency, and mortgages structured for sale as bonds give a higher priority to constantly receiving some sort of income and therefore require a clause which allows the lender to take the property immediately, regardless of bankruptcy proceedings that the borrower might be going through.
Frequently, the mortgage is supplemented by a general obligation of the borrower or a personal guarantee from the owner(s), which makes the debt payable in full even if foreclosure on the mortgaged collateral does not satisfy the outstanding balance.
Terms of a commercial mortgage
The majority of Commercial Mortgages in the United States, while requiring the borrower to simply make a monthly payment small enough to pay off the loan over a 20 to 30 year time frame, require a balloon payment (a total payoff) after a lesser time frame. The borrower most likely will attempt at that time to refinance the loan or sell the property. Thus there are two elements generally to the term of a commercial mortgage loan: the length of time allowed until balloon payment (known simply as the term), and the amortization. The length of the loan can vary from a matter of days to 30 years. If a loan had a 30 year amortization schedule, but a 10 year term it would commonly be referred to as a 10 year balloon with a 30 year payment schedule.
As an example, assume a $15,000,000 loan at 8% interest with a 30 year amortization schedule and 10 year term (a 10/30 loan) with monthly payments. The payment amount would be $110,065 per month or $1,320,776 per year if it were on a typical 360 day accrual (in Excel: =PMT(8%/12,30*12,15000000,0)*12 ). The principal balance owed (to the mortgage bank) at the end of each of year would be:
Year $ Balance $ Paid During year 0 $15,000,000 $1,320,776 1 $14,874,695 $1,320,776 2 $14,738,991 $1,320,776 3 $14,592,022 $1,320,776 4 $14,432,856 $1,320,776 5 $14,260,479 $1,320,776 6 $14,073,794 $1,320,776 7 $13,871,615 $1,320,776 8 $13,652,655 $1,320,776 9 $13,415,521 $1,320,776 10 $13,158,706 $1,320,776
At the end of the 10 year loan term, the borrower would have to pay the remaining balance (balloon payment) of $13,158,706. Note: If this table were continued, '$ owed to bank' would reach exactly $0 at year 30 since the loan type is 10/30.
Applications of commercial mortgage loans
Common applications of commercial mortgage loans include acquiring land or commercial properties, expanding existing facilities or refinancing existing debt. Common commercial properties are zoned for office, retail, & industrial purposes.
Commercial premises are purchased for many reasons. One may require bigger premises to cope with expansion, or you may be buying property, whereby the property is directly linked to a business e.g. a hotel. Commercial Mortgages are usually made with terms less than 10 years, but may be much longer than this. The Property itself is usually at risk if payments are not made on time.
Commercial Mortgages are often used for a variety of purposes::
- To purchase the premises of the business.
- For the extension of existing premises.
- Residential and commercial investment.
- Developing the property in other manners.
Most banks and building societies offer commercial mortgages, but applicants must satisfy the lenders' criteria for qualification. The primary criterion is the debt service coverage ratio or the ratio of cash available to the required loan payments. Some lenders may accept applications where there is an adverse credit history, but most require a positive personal credit rating and clear evidence that the business is creditworthy. Most will apply a loan-to-value ratio and will expect the business to invest a proportion of its own money into the purchase.
The lender's decision will also depend on the business' current circumstances, a commercial lender will expect stability and profitability. They may ask to see a business plan as well as long-term financial projections, to assure themselves that the business has, and will continue to have, the ability to make repayments on the loan. Some lenders impose restrictions on the uses of commercial premises and certain business concerns may be excluded altogether. The terms of a commercial mortgage depend largely on the type of business the type of premises or land to be bought.
Commercial Mortgage loans are almost always designed to be underwritten based entirely on the attributes of the property being mortgaged, as opposed to the credit attributes of the borrower. To facilitate this, many times lenders require the property to be owned by a single asset entity such as a corporation or an LLC created specifically to own just the subject property. This allows the lender to foreclose on the property in the event of default even if the borrower went into bankruptcy (the entity is known as "bankruptcy remote"). In a normal residential mortgage, a lender would have a difficult time selling a property if the bankruptcy court case is still pending.
Lenders usually also require a minimum debt service coverage ratio which typically ranges from 1.1 to 1.4; the ratio is net cash flow (the income the property produces) over the debt service (mortgage payment). As an example if the owner of a shopping mall receives $300,000 per month from tenants, pays $50,000 per month in expenses, a lender will typically not give a loan that requires monthly payments above $227,273 (($300,000-$50,000)/1.1)), a 1.1 debt cover.
Lenders also look at Loan to value (LTV). LTV is a mathematical calculation which expresses the amount of a mortgage as a percentage of the total appraised value. For instance, if a borrower wants $6,000,000 to purchase an office worth $10,000,000, the LTV ratio is $6,000,000/$10,000,000 or 60%. Commercial mortgage LTV's are typically between 55% and 70%, unlike residential mortgages which are typically 80% or above.
Interest rates for commercial mortgages are usually higher than those for residential mortgages.
The most common commercial mortgage is a fixed-rate loan, where the interest rate remains constant throughout the term. This must not be confused with the typical residential loan which uses the term to denote a 30 year term mortgage that comes with a rate fixed for 30 years. Most commercial loans have fixed periods between 3 and 10 years. The biggest for this is the source of funds. Many banks borrow their money to lend from the Federal Government with a wholesale cost and repackage the money for retail lending. Since the Fed Rate can change every 3 months or so, banks typically do not want to run the risk of their funds costs exceeding the income derived from interest through a loan made to consumer. These loans are typically based on the yields of treasuries, swaps, corporate bonds, or CMBS rates. Loans can also be variable or capped. These rates are usually based on an index such as LIBOR.
A second commercial mortgage is an additional loan on a commercial property secured behind that of the first lien. The second mortgage is subordinated to the first mortgage and therefore carries a higher interest rate due to the higher risk of not being able to recover all losses should the loan default.
In residential lending in the United States, the market evolved from one where banks extended loans to borrowers, to one where banks extended loans but those loans were securitized and sold off as bonds. The government sponsored enterprises Fannie Mae and Freddie Mac were created to assist banks in doing this, by stamping the bonds with a guarantee of timely payment, even if the homeowner was late on their payment.
However if the commercial mortgage market for apartment buildings of 5 or more units, Fannie Mae and Freddie Mac do even more than this. Essentially they lend their own money and then securtize the bonds themselves, leaving banks to handle the servicing (ie. billing etc.) of the loan. They have come to dominate the market for apartment lending "Commercial/Multifamily Mortgage Debt Grows in Q3". 2008-07-01. http://originatortimes.com/content/templates/standard.aspx?articleid=2700&zoneid=4. Retrieved 2008-07-01. As of December 17, 2007 GSE's were reported to hold 34% of total debt outstanding for multifamily property. Given the recent liquidity crisis due to the sub prime crash of 2007 & 2008, these numbers are reported to be even higher by the Mortgage Bankers Association.
The financial institutions who work to obtain the loans for Freddie Mac or Fannie Mae are then primarily agents, and for this reason this area of lending is known as Agency Lending.
A group called second-layer lenders became an important force in the residential mortgage market in the latter half of the 1960s. These federal credit agencies, which include the Federal Home Loan Mortgage Corp., the Federal National Mortgage Association, and the Government National Mortgage Association, conduct secondary market activities in the buying and selling of loans and provide credit to primary lenders in the form of borrowed money. They do not have direct contact with the individual consumer.
Federal Home Loan Mortgage Corporation
Main article: Federal Home Loan Mortgage Corporation
In 1970 the Federal Home Loan Mortgage Corporation, sometimes known as Freddie Mac, was established. This corporation is designed to promote the flow of capital into the housing market by establishing an active secondary market in mortgages. It may by law deal only with government-supervised lenders such as savings and loan associations, savings banks, and commercial banks; its programs cover conventional whole mortgage loans, participations in conventional loans, and FHAFHA and VA loans.
Federal National Mortgage Association
Main article: Federal National Mortgage Association
Known in financial circles as Fannie Mae, this association was chartered as a government corporation in 1938, rechartered as a federal agency in 1954, and became a government-sponsored, stockholder-owned corporation in 1968. Fannie Mae, which has been described as "a private corporation with a public purpose", basically provides a secondary market for residential loans. It fulfills this function by buying, servicing, and selling loans that, since 1970, have included FHA-insured, VA-guaranteed, and conventional loans. However, purchases outrun sales by such a wide margin that some observers view this association as a lender with a permanent loan portfolio rather than a powerful secondary market corporation.
Government National Mortgage Association
Main article: Government National Mortgage Association
This association, which is often referred to as Ginnie Mae, operates within the Department of Housing and Urban Development. In addition to performing the special assistance, management, and liquidation functions that once belonged to Fannie Mae, Ginnie Mae has an important additional function — that of issuing guarantees of securities backed by government-insured or guaranteed mortgages. Such mortgage-backed securities are fully guaranteed by the U.S. government as to timely payment of both principal and interest..
In the early 1980s, Investment Banks such as Salomon Brothers worked with banks and the government sponsored entities Fannie Mae and Freddie Mac to develop ways for banks to be able to sell their home mortgage loans as bonds into the bond market. By doing this, banks would free up funds to continue to make more loans, as well as earn fees upon the sale of the loans while leaving little or no of their own money at risk. However, similar developments in commercial mortgages were slow in appearing. The first movement in this area came with the savings and loan failures: the government set up a company known as the "resolution trust company" which would buy commercial mortgages from failed savings and loans and then turn them into bonds. In the early to mid nineties this led the staff of the Japanese Investment Bank Nomura in San Francisco to develop programs to convert commercial mortgages into bonds, primarily by making new commercial mortgage loans with clauses and structures which make them more like what bond investors want to invest in. The main thing that bond investors did not like about mortgages is that the borrower could repay the loan at any time (which was usually done when interest rates went lower, causing the bond investor to lose out on their high rate bond and having then to reinvest in new low rate bonds). While the government did not like restrictions on prepayment penalties being required of regular home owners, Nomura and other investment banks began to structure commercial mortgages that absolutely forbid prepayment, in exchange for dramatically lower interest rates (and also allowing new buyers of the property to take over the existing loans, in other words, making them assumable). The loans that were especially designed to be turned into bonds became known as "conduit loans". Because of the rule against prepayment, for a borrower to prepay a conduit loan, the borrower will have to buy enough government bonds (treasuries) to provide the investors with the same amount of income as they would have had if the loan was still in place. This is known as a defeasance. When a property defeases, the bond it is in will increase in value since the higher risk real estate collateral is being replaced with lower risk US treasuries.
Conduit loans have been part of a trend in the Investment Banking industry to become more "vertically integrated". That is, instead of helping banks and other lenders to provide fix rate products and replenish funds by selling off loans as bonds, investment banks have taken to making the loans themselves, and then selling the bonds themselves. In fact, many times the Investment Banks make little or no money on the loan itself, and only make money by the selling and trading of bonds. For this reason, these forms of loans are usually at a better interest rate than is possible through other forms of Bank lending.
Like most residential mortgage loans that are sold as bonds to bond investors, investment banks usually create multiple classes (known as 'tranches') of bonds based on the same pool of mortgages. The tranches might be ranked so that the 1st class takes all of the losses on the mortgage loans up to a certain point in exchange for having a higher interest rate paid to them. The second class may only take losses when the losses reach a certain point for the first class of bondholders, in exchange for a lower interest rate. In this way one set of mortgages could be used to create bonds that appeal to a wide range on investors.
With the subprime mortgage crisis, investors have stopped buying the majority of classes of commercial mortgage backed securities, and therefore, most conduit loans are no longer available at good interest rates. This is due to a few factors: while there is concern that the residential mortgage crisis will have an adverse effect on commercial real estate, the biggest issue is that both subprime mortgage bonds as well as commercial mortgage bonds have been arguably constructed incorrectly, with the investment banks underestimating the losses that might occur for each tranche and under compensating the tranches as a result (and also underpricing the original loan). It is not clear at this time whether new commercial mortgage backed securities will again begin to be issued in an orderly fashion, and if so whether the tranche system might be changed fundamentally. However this is an issue for the commercial real estate market in general as other lender (banks, Fannie Mae/Freddie Mac, life insurance companies) will be able to make up for the lost conduit loan availability.
Competition among lenders for loanable funds
To be able to provide homebuyers and builders with the funds needed, financial institutions must compete for deposits. Consumer lending institutions compete for loanable funds not only among themselves but also with the federal government and private corporations. Called disintermediation, this process involves the movement of dollars from savings accounts into direct market instruments: U.S. Treasury obligations, agency securities, and corporate debt. One of the greatest factors in recent years in the movement of deposits was the tremendous growth of money market funds whose higher interest rates attracted consumer deposits.
To compete for deposits, savings institutions offer many different types of plans:
- Passbook or ordinary accounts — permit any amount to be added to or withdrawn from the account at any time.
- NOW and Super NOW accounts — function like checking accounts but earn interest. A minimum balance may be required on Super NOW accounts.
- Money market accounts — carry a monthly limit of preauthorized transfers to other accounts or persons and may require a minimum or average balance.
- Certificate accounts — subject to loss of some or all interest on withdrawals before maturity.
- Notice accounts — the equivalent of certificate accounts with an indefinite term. Savers agree to notify the institution a specified time before withdrawal.
- Individual retirement accounts (IRAs) and Keogh accounts—a form of retirement savings in which the funds deposited and interest earned are exempt from income tax until after withdrawal.
- Checking accounts — offered by some institutions under definite restrictions.
- Club accounts and other savings accounts—designed to help people save regularly to meet certain goals.
- ^ a b c Mishler, Lon; Cole, Robert E. (1995). Consumer and business credit management. Homewood, Ill: Irwin. pp. 121–122. ISBN 0-256-13948-2.
- ^ a b Mishler, Lon; Cole, Robert E. (1995). Consumer and business credit management. Homewood: Irwin. pp. 128–129. ISBN 0-256-13948-2.
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