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Commercial Mortgages

Commercial Mortgages. In this section we will discuss the differences between residential and commercial mortgages Loan terms Underwriting Performance Standardization. Commercial Mortgages.

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Commercial Mortgages

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  1. Commercial Mortgages • In this section we will discuss the differences between residential and commercial mortgages • Loan terms • Underwriting • Performance • Standardization

  2. Commercial Mortgages • A commercial mortgage is a mortgage (note+mortgage) where the collateral that is pledged is an income producing commercial property • Major types • Multifamily • Office • Retail • Hotel • Industrial/warehouse

  3. Commercial Properties • Each type of commercial property represents a unique business with its own unique risks and returns • We will focus on the common attribute that for each type of property, the fee simple owner of the property generates income by leasing the real estate to a user in return for periodic lease payments.

  4. Income Statements • The income statement for a commercial property will have the following format: Potential Gross Income (PGI) -Vacancy Effective Gross Income (EGI) -Operating Expenses Net Operating Income (NOI)

  5. NOI • The Net Operating Income from a commercial property is a measure of the property’s income generating capability and hence the owner’s capacity to service debt. • There can be variations in strategies for getting to NOI, but the bottom line is measured by NOI • NOI is often used to get a rough estimate of the value of a commercial property • Cap rates:

  6. Size of Commercial Mortgage Market

  7. Holdings of Commercial Mortgages

  8. Commercial Mortgages • Largest Commercial Lenders • Banks: B of A, Wells Fargo, Citibank, Life Co. Teacher’s Insurance, Prudential, Metropolitan, AETNA • Spreads:Commercial mortgage spreads over US Treasuries: • Range from 75-225 over 10 year • Long Run Average about 150 bp for best loans • Current averages 200-250bp

  9. Underwriting Commercial Loans • “Three C’s” still generally apply • Capacity measured by DSCR • ratio of NOI to required debt service • Higher numbers (>1)indicate greater cushion • Collateral measured by LTV ratio • Appraised value generally based on income approach to valuation • Present value of future income • Credit measured by track record of owner/manager/developer • Current and past operating results

  10. DSCR Ratios by Type and Time

  11. LTV Ratios by Type & Time

  12. Performance • Commercial Loans are generally viewed as having more credit risk • More “ruthless” exercise of the option to default • Generally no effective recourse to other assets of borrower • Frequently the borrower is a special purpose corporation

  13. Overall Average: 12%-15%

  14. Loss Rates by Property Type

  15. Commercial Loan Characteristics • Balloon loans • Commercial mortgages are generally “balloon” loans. • Maturity of 7, 10 or 15 years • Amortization schedule of 25-30 years • Prepayment Provisions • Most commercial loans cannot be prepaid by the borrower at will • Lockout periods • Yield maintenance provisions

  16. Standardization • Residential loans are very homogeneous • Underwriting standards/mortgage documents/ provisions in the notes are dictated by the major secondary ,market agencies FNMA /FHLMC • Commercial loans are less homogeneous • They can be tailored to specific borrower or property needs

  17. Commercial Loans • Participation Loans • A property may need several years of work to reach its potential NOI • Lenders often believe they bear much of the downside risk of a project but the traditional loan does not let them share in the upside potential

  18. Participation Loans • A mortgage loan with a lower then market rate of interest but that provides that the lender shares or participates in some way in the cash flows of the property • Lender can participate in • Gross income • NOI • Cash flow after regular debt service • proceeds from sale of the property

  19. An Example • Consider Handout Example • Lender offers two loans • 10% standard 15 year mortgage • an 8% loan plus • 50% of all NOI> $100,000 • 45% share of gain from sale of property

  20. Interest-Only Loans • Commercial loans can be interest-only • Borrower payment is equal to the interest rate times the principal balance • Loan does not amortize over the maturity • Full loan amount is due and payable at maturity • 7-10 years • Risk to lender • Without amortization, the lender has less protection against declines in property value • Benefit to Borrower • Reduces cash flow requirements • All debt service is tax-deductible

  21. Split-Rate or Accrual Loans • If the borrower’s payment is set below the amount needed to pay interest, the loan will “negatively amortize” • Saw this in ARMs with payment caps • Loans can be set with one rate at which they earn interest for the lender (accrual rate) and a second rate used to determine the payment (pay rate)

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