Commercial Mortgage Refresher Course

Commercial mortgages are a popular asset class for many investors. But with so many different types of financing available, how do you know which one is best for your situation? Many people who invest in commercial mortgages are ill-equipped to make that decision without a little education.

This post provides some background on the different types of commercial mortgages and walks through the process of deciding which one is right for you. It also covers some common misconceptions about commercial mortgage investing and what to watch out for when selecting financial partners - because while these loans can be relatively straightforward, they're not always as simple as they seem.

Understanding the commercial mortgage structure

When you're talking about commercial mortgages, it is important to understand the structures of each type. The first commercial mortgage you'll encounter is a senior loan. A senior loan is just that - the principal amount is always greater than any other outstanding loans on the property. The second type of loan structure you'll see is an unsecured senior loan. An unsecured senior loan has no collateral and therefore no repayment power should the interest rates rise or market conditions change. However, unsecured senior loans offer significantly lower interest rates than secured loans, which have collateral from same-size properties backing up the mortgage. The third type of commercial mortgage structure is a secured junior loan. These loans are secured by the same property that backs up the senior loan, but because they are junior in priority, they are repaid after every other outstanding balance on the property. This type of loan is typically used as a low-cost financing option for smaller businesses with limited capital or significant debt levels.

Understanding your own risk tolerance

Commercial mortgages can be very rewarding investments in the right situations. But they also carry a higher degree of risk than many other types of loans. That's why it's so important to understand not only your appetite for risk in general but also how your situation may affect that appetite. For example, a senior loan for a commercial property you're not personally involved in may be the more prudent option if you're planning to hold on to the property for several years. But if you're unsure about your ability to find another buyer should the market turn against this type of investment, an unsecured junior loan may be better.

Likewise, you'll want to assess each financing structure's impact on conflict-of-interest issues. Be sure that your financial partner understands their responsibilities in terms of protecting your interests and that they are prepared to back up their promises with action. If your partner is seeking any degree of control over the borrower, you should have a carefully constructed exit strategy in place other than selling the property outright. Many investors make mistakes by assuming that a senior loan is the only option for financing commercial mortgages. While a senior loan may be best in some situations, an unsecured senior loan can be just as good of an option. In both cases, it may be important to establish a high degree of trust with your lender.

Complexities in commercial mortgage investing

Commercial mortgages are relatively straightforward investments if you're well-educated about their structure and risks. But they've also become more complicated in recent years with the expansion of technology, alternative financing structures and the rise of alternative asset classes. It's important to understand that - as long as you're prepared to invest enough time and money to make sure you understand all aspects of your situation - a commercial mortgage can be an excellent investment.

Commercial mortgage basics for investors

The first step in seeking out a commercial loan is to educate yourself about the risks and rewards that are available. Many borrowers turn to a bank rather than an independent investment banker for their financing because banks have access to a wider range of financing options than independent brokers do. But that doesn't mean that banks are always the best financial partners for every situation. An independent broker can offer insight and advice on a wide variety of options for financing, including both senior and junior loans.

You'll also want to make sure that you understand the difference between the senior and unsecured junior loan structures. Because the junior loan is secured by the underlying mortgage, there's less risk of default if interest rates rise or market conditions change - in other words, you're more likely to receive your payments than if you were using an unsecured senior loan. But you should be aware that while collateral backing up a senior loan will give it more power to be paid out of default in many situations, that power is dependent upon the lender having some ability to secure a sale through foreclosure or bankruptcy proceedings.

The average cost of a commercial mortgage is constantly on the rise. But that doesn't mean that you need to fly to New York, Los Angeles or Hong Kong just to secure a loan. Instead, you may be able to find the financing for your business in your own community. With today's high-tech tools, you can find lenders who are eager and able to lend money without having to step foot in a bank or other financial institution's office.

If you're seeking out a local investment partner for your business property, here are some questions to ask:

How long have they been in business? Many local lending institutions are new players in this market and have only been around for less than five years. As a result, you shouldn't feel compelled to select a lender based on the length of their experience, but that should be a consideration.

How do they find financing for my type of property? Local lenders often have access to a wide range of products through their relationships with real estate investment trusts (REITS) and other specialized investors. Of course, you need to check what type of ranking your lenders receive through third-party databases - and make sure they meet your standards.

Are there any special requirements I must meet? Many lenders will require that you personally guarantee the loan if you want to use an unsecured junior loan for your commercial property. That way, if you don't make your payments, they can pursue you for the funds.

How do they fund the loan? This is an important question because you need to be sure that your lender will be able to keep its promise.

Why do they choose this type of loan structure over others? As a new business owner, you'll probably end up dealing with business loans more often than commercial mortgages. But that doesn't mean it's impossible to obtain financing for your commercial property without a personal guarantee. With a more detailed understanding of the available structures and their implications, however, it is possible to avoid putting yourself into a position of potential liability on the property.

How involved will my partner be? In many cases, you'll want an independent investor to simply find the financing for your commercial property - but you can also choose a broker who's willing to work with you on a more hands-on basis and share the financial responsibility with you if necessary.

What are their timeframes? In most cases, your lender will want to hold title over the property until your debt has been paid off. However, this can vary depending on what type of loan structure you select. With an unsecured junior loan, you're likely to have more negotiating power with your lenders since they must extend credit to secure repayment of the principal amount owed on the mortgage.

Conclusion

A commercial loan can be just as good of an investment as a residential loan - but you'll need to invest the time necessary to educate yourself about the risks, rewards and available financing options. Fortunately, there are many ways to secure commercial financing for your business property, including an unsecured senior or junior loan. Your primary consideration is to make sure that you're comfortable with all of your lender's terms and conditions before you finalize your decision on the financial partner who'll finance your next business property.

For more information on financing options for commercial properties visit: http://www.investmentcommercialrealestate.