Commercial Mortgage Finance basically refers to a loan, which is made, and where the concerned real estate is used as collateral for securing the repayment of the same and other corresponding issues related to the financing of the commercial property.
Commercial mortgage is slightly different from the residential one in the sense that: -
- The collateral in case of commercial mortgage is commercial building or other business estate, whereas in case of residential mortgage the collateral is the residential property.
- Commercial mortgages are primarily taken by the business entities like partnership firms, incorporated businesses, or limited companies whereas residential mortgages are taken by the individuals.
Basically, commercial mortgages are non-recourse in nature where in case of a default in repayment, the creditor is entitled to seize only the collateral. If there remains any shortfall in payment even after the seizing of the collateral then the lender would have no right of any other claims from the borrower.
The time span for a usual commercial real estate loan ranges from 20 to 40 years. Commercial mortgages are highly customized ones, which are pegged to a base rate and sometimes are also made at fixed rates.
Standards of Underwriting
Almost all commercial mortgages are underwritten depending on the attributes of the mortgaged property. For facilitating this, the lender makes the property to be owned by a single asset entity, like corporation. In case of default where the borrower has become bankrupt, this process helps the lender to foreclose on the property. Mortgagors also require a minimum debt service coverage ratio. Debt service coverage ratio generally ranges from 1.2:1 to 1.35:1. Debt service coverage ratio is calculated as difference between revenues and expenses excluding mortgage payment over the mortgage payment.
Terms of Commercial Mortgages
In USA, borrower of the commercial mortgage is required to make a balloon payment after a short time period, say, 10 years. At that time, the debtor tries to refinance the loan. Hence, the term of a commercial mortgage has two elements:-
- The time period allowed until the payment of the total payoff or balloon payment,
- Amortization.
Agency Mortgage
In USA, banks give loans, which are security in nature, and these loans are salable as bonds. Thus, government has created two enterprises, (1) Freddie Mac and (2) Fannie Mae, for assisting it by stamping the bonds with guarantee of timely payment, even if the owner is running late on his/her timely payment. These two enterprises actually lend their own money and then they themselves secure the bonds and are now the dominant lenders of the apartment lending market. These two enterprises are basically agents, and that is why this form of lending is known as the Agency Lending.
Conduit Mortgages
Investment banks are turning more and more towards vertical integration, where they themselves provide loans and then sell the bonds. Similarly, the conduit loans or commercial mortgages generally have standardized guidelines so that they could be sold off as commercial mortgage backed securities.
Disadvantages of conduit mortgages are also glaring: -
Commercial mortgage backed securities always want their investment to remain at a fixed rate for a fixed span of time. So, in order to give same amount of income to the investors at par with the fixed interest rate of the loan, the debtor has to buy enough government bonds for prepaying a conduit loan.
Now, let us checkout
three situations: -
(a) Interest rate remains the same: - Since the rate of interest of the government bonds are less, so the borrower would have to buy more bonds than his present owing.
(b) Interest rate decreases: - The borrower would have to buy even more government bonds than the first case which makes the situation virtually impossible for the borrower to refinance in order to avail the lower rates.
(c) Interest rate increases: - The borrower can actually make money by prepaying early.
Interest Rates
Interest rates are usually higher for the commercial mortgages than that of the residential ones.
Commercial mortgages are of two types: -
1. Fixed-rate loan: - where the rate of interest remains constant throughout the life-span of the loan.
2. Second commercial mortgage: - where an additional loan on an already mortgaged property can be taken. Second commercial mortgage generally carries a higher interest rate because it is subordinate to the first mortgage.
Challenges to Commercial Mortgages
Lenders of commercial mortgage face the following risks and challenges:-
1. Payment default or payment delinquency
2. Discrepancies related to valuation and appraisal
3. Rights of lean teachers
4. Redemption, foreclosure, sale and auction
If the expected income from the property falls unexpectedly then the lenders become the direct owner of the property. These issues when produced in court are usually long drawn and the ruins of the property and the relationship remain.
Alternative Dispute Resolution (ADR) is an efficient way of resolving commercial mortgage disputes without the legal hassles, delays and expenses.