Commercial Property - Conventional Mortgages
Conventional commercial property loans are mortgages that are provided by a bank, credit union, savings institution, or other traditional financial institution and are secured by a first lien position on the subject properties being financed. The collateral may be any type of commercial real estate and do not always require previous experience. Property types include office, retail, industrial, self-storage, churches, gas stations, sporting facilities, among many others. These loans are typically best suited for inexperienced borrowers, small loan balances, specialty properties, or any other structure that may require a personal guaranty.
Conventional Lenders typically have maximum LTVs of 75-80%, while some lenders can stretch up to 85% in limited circumstances for especially strong borrowers. Borrowers should expect to have “hard cash” equity invested in purchase transactions, while being able to maintain a post-closing liquidity sufficient to service their debt for several months and an overall net worth equal to or greater than the loan amount (although there may be some flexibility). Properties will need to be able meet a DSCR of 1.25-1.55x (depending on the LTV and property type) at the underwriting rate.
Conventional Loan Features
Term Length/Amortization: The length of term and amortization depends heavily on the institution providing the funding as well as the property type. Terms can vary from 3-15 years with amortizations ranging from 10-30 years. Depending on the way the loan is structured, it may “balloon” at the end of the term, meaning at the loan balance will need to either be refinanced or paid off; otherwise the loan is self-amortizing, meaning that the loan will be fully paid off when the loan matures, so there is no loan balance to pay off (unless the loan is prepaid before it matures).
Recourse: Conventional loans may be non-recourse, limited recourse, or full recourse loans. If it is non-recourse, the Borrowers are not personally liable for the repayment of the loan and that the collateralized property and its cash flows would be the sole source of repayment of the debt in the event of a default or foreclosure. However, in the event the Borrower actively participates in an activity that could cause harm to the property, there could be springing recourse in some limited circumstances; this may include loan fraud, property transfer or subordinate financing without consent of the Lender, and voluntary or collusive activity leading to a bankruptcy filing, among other such actions. Limited recourse loans makes the sponsors guarantying the loan responsible for a percentage of any shortfall between the loan balance and sales price in the event of default and foreclosure, where the property must be auctioned off as well as any applicable legal and ancillary fees. The carve outs for the non-recourse loans would also apply. Full recourse loans make the sponsors guarantying the loan responsible for any and all shortfalls between the loan balance and sales price in the event of default and foreclosure as well as any applicable legal and ancillary fees.
Loan Assumption: A conventional loan may or may not be assumable. Typically assumption occurs when the Borrower wants to sell the commercial real estate that secures the loan, and the Purchaser of the property wants to take the loan over. Once the property sale and assumption is completed, the Purchaser becomes the owner of the property and is bound by the original terms of the assumed loan and the original Borrower/Seller is released from its obligation to the property and the existing loan. The benefit of this structure is that the assumption of the loan allows the Borrower/Seller to avoid pre-payment costs and give the buyer the opportunity to assume a loan that may have favorable terms than what is market. Loan assumption is an especially attractive option in high interest rate environments or tight credit environments.
Prepayment Penalty Structures
Prepayment penal structures vary greatly depending on the institution funding the transaction. It may be structured as Yield Maintenance, Breakfunding, Declining (or step-down) prepayment penalty, or may be specially structured to suit a construction or mini-perm loan.
Yield Maintenance: The goal of Yield Maintenance is to allow the bond investors to maintain the same yield as if the borrower made all scheduled mortgage payments until maturity. The penalty is typically calculated by a formula contained in the Note of the Loan Documents. The language will vary between different institutions, but will typically have the same two amounts to be repaid, namely: 1) The loan’s unpaid principal balance and 2) a prepayment penalty, which is typically determined by calculating the difference between the loan’s interest rate and the replacement rate (based on the US Treasury or other index that most closely corresponds to the maturity date), with the remaining loan payments discounted back for the time value of money. One thing to keep in mind is that yield maintenance provisions usually contain a prepayment penalty “floor” of at least 1% and allow for prepayment without penalty in the last 3-6 months of the loan. See the following example for a more mathematical representation of this calculation: (Loan balance at time of payoff) * (note rate - new cost of funds) * (# years left in loan) * (365/360)
Breakfunding: Breakfunding is used in order to prevent the Lender from taking an economic loss due to prepayment of the loan before the maturity date, but the Lender doesn’t make money from the amount due. Breakfunding compares the original cost of funds to the cost of funds at the time of the loan prepayment. This difference is then multiplied by the then loan balance and the remaining time on the loan, with the total being discounted back for the time value of money. See the following example for a more mathematical representation of this calculation: (Loan balance at time of payoff) * (original cost of funds - new cost of funds) * (# years left in loan) * (365/360)
Declining (Step-Down) Prepayment Penalty: A declining prepayment penalty may be structured in a variety of ways, but always has the same feature of the prepayment penalty lessening by 1% per step with the last 3-12 (or more) months open to prepay or refinance without penalty. These are usually offered on shorter-term loans (i.e. 5-10 years), but could potentially be offered on longer terms as well. An example of a 5 and 10 year declining prepayment penalty would be the following:
- 5 Year Declining: 5% of loan amount if prepaid in the first year, 4% if prepaid in the second year, 3% if prepaid in the third year, 2% if prepaid in the fourth year, and 1% if prepaid in the fifth year, also represented as 5-4-3-2-1% or 5% declining.
- 10 Year Declining: 5% of loan amount if prepaid in the first or second year, 4% if prepaid in the third or fourth year, 3% if prepaid in the fifth or sixth year, 2% if prepaid in the seventh or eighth year, and 1% if prepaid in the ninth or final year, also represented as 5-5-4-4-3-3-2-2-1-1% or 5% declining.
Conventional Loan Servicing
Conventional Loans are typically serviced by the funding institution, the originator, or a third party servicer. The Master Servicer is responsible for day-to-day loan servicing practices including collecting loan payments, managing escrow accounts, analyzing financial statements inspecting collateral and reviewing borrower consent requests. All non-performing mortgages are usually sent to the special servicer. The special servicer is responsible for preforming customary work-out related duties including extending maturity dates, restructuring loans, appointing receivers, foreclosing the lender’s interest in a secured property, managing the foreclosed real estate and selling the real estate. Under some situations, master servicers subcontract some of their responsibilities to a primary or sub servicer in order to uphold the servicing standard when they need additional assistance.