Loans which are granted against property- residential or commercial- belonging to the borrower are known as mortgage loans. If the borrower fails to repay the loan, the lender recovers the loan money by selling the mortgaged property.
One may borrow loans not only against the property one resides in but also properties from which one earns rental income. The property may be an office building, a mall, a hotel or even an apartment building. Such loans granted against commercial property are known as commercial mortgage loans. If residential property is mortgaged, the loan is called a residential mortgage loan.
In the case of a residential mortgage loan default, if the sale proceeds of the mortgaged property are insufficient to recover the loan amount, the lender has recourse to the borrower. Commercial mortgage loans on the other hand are nonrecourse loans. This means that the lender can recover the borrower’s dues on interest as well as principal only from the amount received from the sale of the mortgaged property. This is the reason why lenders thoroughly evaluate the risks involved before approving commercial mortgage loans.
Lenders use the following risk indicators to evaluate commercial mortgage loan risks:
The lender of a commercial mortgage loan would first calculate the debt to service coverage ratio.
Debt to service coverage ratio = Mortgaged property’s net operating income: Debt serviced.
Net operating income is the rental income after deducting operating expenses. A ratio greater than one indicates that the borrower can comfortably service the debt from the income received from the mortgaged property.
This is another risk assessment ratio used by lenders.
Loan to value ratio = Mortgage amount: Appraised value of property
The higher the ratio, the greater is the risk to lenders. To compensate for this risk, the lender may charge a higher interest rate or the borrower may need to buy mortgage insurance.
Prepayment of Commercial Mortgage Loans
Borrowers of mortgage loans often prepay their loans to take advantage of a fall in interest rates. They repay the existing loans and take new loans at lower rates. Generally, prepayment of residential mortgage loans does not invite penalty. Borrowers of commercial mortgage loans however, are penalized for prepayment by a clause included in the loan agreement.
The loan contract may specify the period of prepayment lockout generally a period of 2 to 5 years from the date of issue of loan.
When the contract contains the clause of ‘defeasance’, the borrower instead of prepaying the loan can invest that amount in treasury securities. The income from the securities is used to pay the loan installments. The lender benefits from this as his risk is reduced though he will be paid regular installments. If the treasury rate is higher than mortgage rate, the borrower also will profit from defeasance.
If the agreement provides for prepayment penalty points then the borrower will have to pay a penalty. 5-4-3-2-1 system is common wherein the borrower is charged 5% repayment penalty in the first year, 4% in the second year and so on. Penalty points are however seldom used in contracts of commercial mortgage loans.
This clause makes it unprofitable for the borrower to shift commercial mortgage loans by imposing a yield maintenance charge. Different lenders may use different forms of yield maintenance charge. This could be the difference between the mortgage coupon rate and the current treasury rate. Bullet model, single discount factor model, truncated interest difference model are some of the other kinds of yield maintenance charge.
One can take commercial mortgage loans and use the regular income from the mortgaged commercial property to service them. Since these loans are nonrecourse, the other assets of the borrower are not at risk.