Commercial mortgage

A commercial mortgage is a mortgage loan secured by commercial property, such as an office building, shopping center, industrial warehouse, or apartment complex. The proceeds from a commercial mortgage are typically used to acquire, refinance, or redevelop commercial property.

There were $3.1 trillion of commercial and multifamily mortgages outstanding in the U.S. as of June 30, 2013. Of these mortgages, approximately 49% were held by banks, 18% were held by asset-backed trusts (issuers of CMBS), 12% were held by government-sponsored enterprises and Agency and GSE-backed mortgage pools, and 10% were held by life insurance companies.

Terms

Loan amount

The loan amount of a commercial mortgage is generally determined based on loan to value (LTV) and debt service coverage ratios, more fully discussed below in the section on underwriting standards.

Loan structure

Commercial mortgages can be structured as first liens or, if a greater loan amount is desired, the borrower may be able to obtain subordinate financing as well, sometimes structured as a mezzanine note or as preferred equity, which generally carries a higher interest rate.

Interest rate

Interest rates for commercial mortgages may be fixed-rate or floating rate. Fixed-rate mortgages on stabilized commercial real estate are generally priced based on a spread to swaps, with the swap spread matched to the term of the loan. Market interest rates as well as underwriting factors greatly affect the interest rate quoted on a particular piece of commercial real estate. Interest rates for commercial mortgages are usually higher than those for residential mortgages.

Fees

Many commercial mortgage lenders require an application fee or good-faith deposit, which is typically used by the lender to cover underwriting expenses such as an appraisal on the property. Commercial mortgages may also have origination or underwriting fees (paid at close as a reduction in loan proceeds) and/or exit fees (paid when the loan is repaid).

Term

The term of a commercial mortgage is generally between five and ten years for stabilized commercial properties with established cash flows (sometimes called "permanent loans"), and between one and three years for properties in transition, for example, newly-opened properties or properties undergoing renovation or repositioning (sometimes called "bridge loans"). Mortgages on multifamily properties that are provided by a government-sponsored enterprise or government agency may have terms of thirty years or more. Some commercial mortgages may allow extensions if certain conditions are met, which may include payment of an extension fee. Some commercial mortgages have an "anticipated repayment date," which means that if the loan is not repaid by the anticipated repayment date, the loan is not in default.

Amortization

Commercial mortgages frequently amortize over the term of the loan, meaning the borrower pays both interest and principal over time, and the loan balance at the end of the term is less than the original loan amount. However, unlike residential mortgages, commercial mortgages generally do not fully amortize over the stated term, and therefore frequently end with a balloon payment of the remaining balance, which is often repaid by refinancing the property. Some commercial mortgages have an interest-only period at the beginning of the loan term during which time the borrower only pays interest.

Prepayment

Commercial loans vary in their prepayment terms, that is, whether or not a real estate investor is allowed to refinance the loan at will. Some portfolio lenders, such as banks and insurance companies, may allow prepayment flexibility. In contrast, for a borrower to prepay a conduit loan, the borrower will have to defease the bonds, by buying 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.

Borrower entity

A commercial mortgage is typically taken on by a special purpose entity such as a corporation or an LLC created specifically to own just the subject property, rather than by an individual or a larger business. This allows the lender to foreclose on the property in the event of default even if the borrower has gone into bankruptcy, that is, the entity is "bankruptcy remote".

Recourse

Commercial mortgages may be recourse or non-recourse. A recourse mortgage is supplemented by a general obligation of the borrower or a personal guarantee from the owner(s) of the property, which makes the debt payable in full even if foreclosure on the property does not satisfy the outstanding balance. A nonrecourse nonrecourse mortgage is secured only by the commercial property that serves as collateral. In an event of default, the creditor can foreclose on the property, but has no further claim against the borrower for any remaining deficiency.

If a sponsor is seeking financing on a portfolio of commercial real estate properties, rather than a single property, the sponsor may choose to take out a cross-collateralized loan, in which the all of the properties collateralize the loan.

Reserves

Lenders may require borrowers to establish reserves to fund specific items at closing, such as anticipated tenant improvement and leasing commission (TI/LC) expense, needed repair and capital expenditure expense, and interest reserves.

Underwriting

Underwriting metrics

Lenders usually require a minimum debt dfdfwefsfsfservice 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.

Lenders look at rents per square foot, cost per square foot and replacement cost per square foot. These metrics vary widely depending on the location and intended use of the property, but can be useful indications of the financial health of the real estate, as well as the likelihood of competitive new developments coming online.

Since the financial crisis, lenders have started to focus on a new metric, debt yield, to complement the debt service coverage ratio. Debt yield is defined as the net operating income (NOI) of a property divided by the amount of the mortgage.

Underwriting practices

Lenders typically do thorough due diligence on a proposed commercial mortgage loan prior to funding the loan. Such due diligence often includes a site tour, a financial review, and due diligence on the property's sponsor and legal borrowing entity. Many lenders also commission and review third-party reports such as an appraisal, environmental report, engineering report, and background checks.

Providers of commercial mortgages

Banks

Banks, large and small, are traditional providers of commercial mortgages. According to the Federal Reserve, banks held $1.5 trillion of commercial mortgages on their books as of June 30, 2013.

Conduit lenders

Conduit lenders originate commercial mortgages and hold them as investments for a short period of time before securitizing the loans and selling CMBS secured by the underlying commercial mortgage loans. Conduit lenders include both banks and non-bank finance companies. Approximately $560 billion of commercial mortgages were held by issuers of CMBS as of June 30, 2013, according to the Federal Reserve.

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.

Government agencies

Government-sponsored enterprises such as Fannie Mae and Freddie Mac, as well as government corporations such as the Government National Mortgage Association or Ginnie Mae, are active lenders for multifamily commercial real estate in the United States. Approximately $390 billion of multifamily residential mortgages were held by government-sponsored enterprises or Agency and GSE-backed mortgage pools as of June 30, 2013, representing 12% of total commercial mortgages outstanding and 43% of multifamily commercial mortgages outstanding at that time.

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 in 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 (i.e. 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. 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.

These federal credit agencies, which include the Federal Home Loan Mortgage Corporation or Freddie Mac, the Federal National Mortgage Association or Fannie Mae, and the Government National Mortgage Association or Ginnie Mae, 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.

Insurance companies

Insurance companies are active investors in commercial mortgages, and hold approximately $325 billion of commercial mortgages as of June 30, 2013.

Mortgage brokers

Mortgage brokers do not provide commercial mortgage loans, but are often used by to obtain multiple quotes from different potential lenders and to manage the financing process.

References

• US Commercial Mortgage Guide
• UK Commercial Mortgage Guide

External links

• Template:Dmoz
• FHA loans (Department of Housing and Urban Development)
• FSA Consumer page UK regulator mortgage information.
• ABC's of Mortgages, Financial Consumer Agency of Canada
• Research Whitepapers on Commercial Real Estate Mortgages in CMBS and the use of Commercial Mortgages by REITs