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Some Important Facts About First Position Commercial Mortgage Notes
Generating attractive interest is a challenge in today’s low interest rate environment. The attractiveness of First Position Mortgage Notes lies in the fact that investors (lenders) are held in first place as lien holders on real estate – so there is a solid asset (real estate) that ensures the security of their investment.
The 50-year average for home ownership in the United States is about 65%. Most experts see that number shrinking as the shift to rental communities continues to grow along with the challenges younger consumers face in securing sustainable employment that is directly related to one’s ability (and desire) to own a home. Marketing for traditional home mortgage financing in today’s market has created a better understanding of how these loans work for consumers. Couple 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?
Everyday consumers leave their homes and visit multiple commercial properties – for work – for dining – for shopping – for entertainment – but few understand the differences between the commercial finance market and the home finance market. The term “commercial loans” is mainly segmented into “multifamily properties (5 plus units), office buildings, retail centers, industrial and warehouse spaces, single-tenant buildings (such as Lowes and Walmart), and special-use properties such as are gas stations, schools, churches, etc. Regardless of the purpose, the approach to commercial loans is quite different from residential borrowing.
With home loans, it is common procedure for the lender to request 2 years of tax returns, bank statements, payslips, credit checks and property appraisals. The primary focus of the loan underwriter 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 service the loan outside of cash flow from day-to-day operations. The lender will ask for copies of current leases (rent) and two years of the borrower’s business history. In addition, they will review recent capital improvements, interior and exterior photos of the property, and lien and title searches. With these documents in hand, the sponsor will create a debt service coverage ratio (DSCR) to determine if the property can cover the requirements that will come with the new loan. 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 strong financial and credit history to qualify for a loan. However, the lender places the most weight on the property’s ability to support the loan relative to the borrower’s personal situation. This is in direct comparison to the underwriting of residential mortgages where the borrower’s personal financial situation is of greater importance than the assets that are 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 Money/Hard Money Lenders.
Portfolio Lenders – these are mainly made up of banks, credit unions and corporations that participate in commercial loans and hold them on their books until the maturity date.
State agency lenders – these are companies that are authorized to sell commercial credit 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 the trust, which in turn issues a series of bonds with different terms (length and rate) and payment priorities in the event of default.
Insurance companies – many insurance companies have looked to the commercial mortgage market to increase the yield on their properties. 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 normal lending norms.
SBA loans – Borrowers looking to purchase commercial real estate for their own use (owner-occupied) have the option of using an SBA-504 loan that can be used for a variety of purchases for their own business, including real estate and equipment.
Private cash/hard cash 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 their intended project. 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 mortgage loans can be either recourse or non-recourse by 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 income is insufficient to repay the entire loan. With non-recourse loans, the property is collateral and the borrower is not personally responsible for the mortgage debt. In typical non-recourse 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, felonies, misappropriation of property income, and insurance windfalls, the lender may hold the borrower(s) personally liable for the mortgage debt.
It is understandable that in commercial mortgage negotiations, lenders prefer recourse loans, while borrowers would prefer no recourse loans. In the process of taking the loan, the lender and the borrower(s) work to create a loan that meets the needs and goals of both parties, and if there is a deadlock – 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 real estate liens, and terms (12 months to 5 years) that are acceptable to most. Generating constant monthly interest through holdings such as commercial mortgage notes is attractive to both consumers and institutional investors.
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