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.
Commercial mortgages are structured to meet the needs of the borrower and the
lender. Key terms include the loan amount, interest rate, term,
amortization schedule, and prepayment flexibility. Commercial mortgages are
generally subject to extensive underwriting and due diligence prior to
closing. The lender's underwriting process may include a financial review
of the property and the property owner, as well as commissioning and review of
various third-party reports, such as an appraisal.
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, 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 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 and/or
exit fees. = Term =
The term of a commercial mortgage is generally between five and ten years for
stabilized commercial properties with established cash flows, and between one
and three years for properties in transition, for example, newly opened
properties or properties undergoing renovation or repositioning. 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 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 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 expense, needed repair and
capital expenditure expense, and interest reserves.
Underwriting = Underwriting metrics =
Lenders usually require a minimum debt service coverage ratio which typically
ranges from 1.1 to 1.4; the ratio is net cash flow over the debt service. 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 $227,273/1.1)), a 1.1
debt cover. Lenders also look at loan to value. 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 of a property divided by the amount of the mortgage.
= Underwriting practices = Lenders typically do thorough extreme
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.
Securitization of commercial mortgages in its current form began with the
Resolution Trust Corporation's commercial securitization program in
1992-1997. The RTC applied an approach similar to the one it had begun
successfully using with residential mortgages, issuing multiple tranches of
securities secured by diversified pools of commercial mortgage loans. Following
the introduction of the securitization methods by the RTC, private banks began
to originate loans specifically for the purpose of turning them into securities.
These loans are typically structured to forbid prepayment beyond a specified
amortization schedule. This makes the resultant securities more attractive to
investors, because they know that the commercial mortgages will remain
outstanding even if interest rates decline.
New CMBS issuance peaked in 2007 at $229 billion. Then, the subprime mortgage
crisis and the resultant global financial crisis caused CMBS prices to
fall dramatically, and new issuances of CMBS securities came to a virtual halt
in 2008-2009. The market has begun to recover, with $12 billion in new
issuance in 2010, $37 billion in new issuance in 2011, and $48 billion in new
issuance in 2012. = Government agencies =
Government-sponsored enterprises such as Fannie Mae and Freddie Mac, as well as
government corporations such as 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. = 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 to obtain multiple quotes from
different potential lenders and to manage the financing process.
= Correspondent Lenders = Correspondent Lenders do not loan their
own money, but provide front end services such as origination,
underwriting, and loan servicing for lenders that utilize these types of
companies. The correspondent often represents lenders in a particular
geographic area. Other markets
= United Kingdom = Commercial mortgage market
Analysis of HM Revenue and Customs data for property transaction completions in
the United Kingdom between 2005 and 2013 shows that, unlike residential lending,
mortgage lending for non-residential property was on the decline prior to the
2008–2009 global recession. Gross commercial and residential lending began
picking up at a similar pace from 2009 onwards, exhibiting 16.2% and 18.2%
non-inflation adjusted growth respectively between 2009 and 2013.
In 2014, commercial lending represented just 5.2% of overall gross mortgage
lending by volume, but 25.3% by value. The average commercial mortgage in this
year was £1.46 million, compared to the average residential mortgage of
£236,400. Slotting
Regulations introduced in 2013 by the Financial Services Authority required
banks to hold a risk-weighted amount of capital against commercial mortgages –
ranging from 50% to 250% of the loan amount – in order to limit their
exposure to commercial property assets. Critics predicted that the larger
capital requirements for large banks could adversely affect the availability
of commercial credit; however, the Bank of England’s 2013 Q4 Credit Conditions
Survey indicated that commercial credit availability to the corporate sector had
increased throughout the year. Regulation
As regulated mortgage contracts are defined as relating to properties that
will be used “as or in connection with a dwelling by the borrower… or a related
person”, individual commercial mortgage contracts and the sale thereof are not
regulated by the Financial Conduct Authority. There is an exception for
mixed-use properties where 40% or more of the property will be used as a
dwelling. By March 2016, however, the UK will be required to have implemented new
rules to comply with the pan-European Mortgage Credit Directive, which does
not draw a distinction between commercial and semi-commercial
properties; it is therefore currently unclear whether all mixed-use properties
will be brought under FCA regulation when the new regulations take effect,
irrespective of the proportion that is used for residential purposes.
Distinction between commercial and buy-to-let lending
In the UK there is a distinction between commercial mortgages, which are for the
purchase of non-residential real estate, and buy-to-let mortgages, which are for
the purchase of residential real estate to let out to paying tenants. Buy-to-let
loans may be offered by both commercial and residential mortgage lenders.
Buy-to-let mortgages share similarities with both commercial and residential
mortgages. Because of high consumer demand and the lower capital offset
requirements, mortgage lenders are able to offer buy-to-let finance at typically
lower interest rates than commercial mortgages. There is also a degree of
regulatory crossover between the buy-to-let and residential markets, and
many buy-to-let lenders employ underwriting checks similar to those
prescribed by the FCA for residential mortgage applications.
Like commercial mortgages, however, buy-to-let mortgages are underwritten
according to debt-service coverage rather than income multiples. High
street banks might calculate DSCR at 160–170% for commercial mortgages and
125–130% for buy-to-let mortgages, while a minority of specialist lenders might
calculate it at 125–130% for commercial mortgages and 110% for buy-to-let
mortgages. References