What Are Commercial Mortgages?
Nov 11, 2016
Most people are familiar with the basics when it comes to residential real estate simply because we are likely to be exposed to the idea of homeownership at some point whether we live in homes, apartments, or yurts. Commercial real estate is different. Unless you own a business or choose to invest in commercial property, there is little reason to understand how a commercial mortgage works. This article is written as a primer for those of us with limited experience with commercial mortgages.
Commercial Real Estate Defined
The way communities across the United States use the land within their boundaries is determined by their local land use policy. The basic type and uses permitted for land is established by a General Plan created for each community. Distinctions are drawn between commercial and residential property as well as agricultural and industrial zones. The maximum density and intensity of use are clearly outlined. Within properties marked for commercial use, there are additional zoning sections providing more specific guidelines around use, building structure, parking required, and display options. Within this framework commercial property is identified and created if zone changes are made.
Commercial Loans versus Commercial Mortgages
Though the terms "commercial loan" and "commercial mortgage" are used interchangeably (even within the commercial finance industry), they are technically different. Commercial loans are the monies offered by a lender that are collateralized by the commercial real estate asset itself. In contrast, a commercial mortgage is a legal agreement that offers a conditional right of ownership by an owner to a commercial lender if rules of payment described in the mortgage note are not met. The mortgage note describes the transaction in detail including the debt amount, due date, monthly payment amounts, prepayment penalties, rate of interest, and the terms of a possible default. State mortgage laws vary with some treating the mortgage as a conveyance of title with the borrower regaining ownership upon loan repayment and others viewing the mortgage as a lien thereby giving the borrower ownership rights as long as the terms of the mortgage are followed.
The Origins of the Commercial Mortgage
The word "mortgage" derives from two French words "mort" and "gage" which combined mean "dead pledge". The "death" referred to is the loss of property which would occur if the pledge is not fulfilled. Adopted by the English in the Late Middle Ages, it was brought to the United States with the original settlers. The first mortgage broker or loan arranger was founded in New York City in 1893. The firm of Sonnenblick-Goldman organized financing for commercial real estate projects which were difficult to fund through informal means. As the American West was being developed, commercial mortgage brokers organized private loans by matching wealthy investors with land developers that were turned down by banks. With the Savings and Loan industry still in its early stages, a common refrain at the time was "the only time a bank will approve my loan is when I prove to the banker that I don't need the loan." The need for private commercial loans to support development and industrialization in the United States, laid the foundation for the commercial mortgage industry.
Commercial Real Estate Essentials
- It's Just Not Personal - In addition to examining your personal financial history, a conventional commercial lender will closely inspect the financial future of the property being financed. They will research the commercial property's condition, current lease roll, operating history, neighborhood valuations, and purchase history. The lender uses this information to produce a debt-service coverage ratio analysis (DSCR) which indicates whether or not the property can support the commercial loan amount in question.
- Sorry No Vacancy - When evaluating a commercial property you have to factor in a realistic vacancy rate. The vacancy rate is the number of "vacant" or unoccupied units available at any particular time. Depending on what type of commercial property you're interested in, this average can vary significantly. For example, according to Statista, in 2015 the national average apartment vacancy rate was 4.8% compared with office space which averaged 12%.
- The Metric System - The two metrics that are the most frequently used to compare commercial real estate are cash-on-cash return and the capitalization rate. The cash-on-cash return measures the annual return made on a property in relationship to the down payment. It is essentially the annual cash income divided by the total dollar investment.
The capitalization rate provides you with an overall rate of return for the money you invested in a property. You find this percentage by taking the Net Operating Income (NOI) and dividing it by the current market value of a property. The trick to this calculation is fully determining the operating expenses which go into calculating the Net Operating Income. It can be difficult to estimate expenses prior to owning a property.
- More "i"s to Dot - Commercial mortgages do require more paperwork than a residential mortgages. A conventional commercial lender not only wants to see a borrower's financial documents but also that of any entity associated with the commercial property being financed, including tax returns, bank statements, and operational statements. They will want to see tenant leases and tenant financial statements as well.
- Improving Flexibility - Commercial Leases are more flexible than residential leases which are highly regulated. While this can be advantageous for commercial real estate investing, it also requires more experience and knowledge to operate a commercial property well. Because commercial leases run longer (decades in some instances), making a mistake can have long-term consequences.
- You Have Options - There are many different commercial lending sources and loan types within commercial finance industry. From commercial hard-money, asset-based lenders to government agencies; a commercial borrower has many options, each with advantages and drawbacks.
- Relationships Take Time - With a traditional commercial lender, you can be far along in the evaluation phase before the completed loan document actually reaches the underwriting process. At this point the terms of the loan can be changed and/or additional conditions can be added. The commercial loan process can take more time to complete with a conventional lender while alternative financing solutions such as a commercial hard money lendercan move along at a faster pace.
- We All Have a Past - There are options for commercial real estate borrowers that have a low credit score due to a limited credit history or an irregular financial background. Most people have had the kind of variability in income at some point in their lives that could be a barrier to obtaining a commercial mortgage from a traditional lender. While a loan from an asset-based lender will have a higher interest rate, the loan terms will be mainly based on the evaluation of the property under development. Commercial hard money lenders have several ways to determine the value of a commercial property.
Commercial Mortgage Fundamentals
The fundamentals of commercial mortgages do play a role in our lives every day. They are an important component of the budgets of every business we come into contact with. If you are looking to invest in commercial real estate then having an overview of the commercial mortgage industry's unique characteristics will help you develop a more nuanced understanding. If you are looking for financing then these commercial mortgage basics should help you get started.