Some Important Facts About First Position Commercial Mortgage Notes

Creating attractive interest is a challenge in today’s low interest rate environment. The attractiveness of First Position Mortgage Notes is in the fact that investors (lenders) are held in the first position as a lien holder of the property – so there is a hard asset (real estate) providing the security of their investment.

The 50-year average for homeownership in the United States is about 65%. Most experts see that number reducing as the move to rental communities continue to rise along with the challenges that younger consumers are finding in securing sustainable employment which is directly correlated to one’s ability (and desire) to own a home. The marketing for traditional residential mortgage financing in today’s marketplace has created a higher understanding of how these loans work for consumers. Couple that with the competition in the residential financing market and it is understandable why most adults understand residential financing. But what about Commercial Real Estate?

Each and everyday consumers leave their homes and visit multiple commercial properties – for work – for dining – for shopping – for entertainment – but few understand that differences in the commercial financing marketplace versus the residential financing marketplace. The term “commercial loans” is mainly segmented into “multi-family properties (5 plus units), office buildings, retail centers, industrial and warehouse space, single tenant box buildings (such as Lowes and Walmart), and specialty use properties such as gas stations, schools, churches, etc. Regardless of the use the access to commercial loans is quite different than residential borrowing.

In residential borrowing the normal procedure is for the lender to request 2 years of tax returns, bank statements, pay stubs, credit check, and appraisal of the property. The loan underwriters primary focus is the borrower’s ability (through an income and expense model) to make the monthly mortgage payments including taxes and insurance.

In a commercial loan the lender will first look at the condition of the property and its ability to service the loan out of the cash flow from its day to day operations. The lender will request copies of current leases (rent roll) and two years of the borrowers operating history. In addition, they will review recent capital improvements, internal and external photos of the property, and lien and title searches. With these documents in hand the underwriter will create a debt-to-service coverage ratio (DSCR) to determine if the property can cover the demands that the new loan will carry with it. In addition, the lender will look at third party appraisals paying attention to not only the property in question but also the surrounding area and the trends in the marketplace.

A commercial borrower needs to have strong financials and credit history to qualify for the loan. However, the lender places the greatest weight on the properties ability to sustain the loan over that of the borrower’s personal situation. This is in direct comparison to the underwriting of residential mortgages where the borrower’s personal financial situation is of a higher concern than the property that is part of the mortgage.

There are six sources for commercial real estate borrowing – Portfolio Lenders – Government Agency Lenders – CMBS Lenders – Insurance Companies – SBA Loans – Private Money/Hard Money Lenders.

Portfolio Lenders – these are mostly comprised of banks, credit unions, and corporations that participate in commercial loans and hold them on their books through the maturity date.

Government Agency Lenders – these are companies that are authorized to sell commercial loan products that are funded by governmental agencies such as Freddie Mac and Fannie Mae. These loans are pooled together (securitized) and sold to investors.

CMBS Lenders – these lenders issue loans called “CMBS Loans”. Once sold the mortgages are transferred to a trust which in turn issues a series of bonds with varying terms (length and rate) and payment priorities in the event of default.

Insurance Companies – many insurance companies have looked to the commercial mortgage marketplace to increase yield on their holdings. These companies are not subjected to the same regulatory lending guidelines that other lenders are and therefore have more flexibility to create loan packages outside the conventional lending norms.

SBA Loans – Borrowers that are looking to purchase a commercial property for their own use (owner-occupied) have the option of utilizing a SBA-504 loan which can be used for various types of purchases for one’s own business including real estate and equipment.

Private Money/Hard Money Loans – For those borrowers that cannot qualify for traditional financing due to credit history or challenges with the property in question – hard money loans may be a viable source of funds for their intended project. These loans have higher interest rates and cost of money than other types of loans. Regardless of the higher costs of borrowing – these loans fill a need in the commercial mortgage marketplace.

Commercial Mortgage Loans can be either recourse or non-recourse in their design. In a typical recourse loan the borrower(s) is personally responsible for the loan in the event that the loan is foreclosed and the proceeds are not sufficient to repay the loan balance in full. In non-recourse loans the property is the collateral and the borrower is not personally held responsible for the mortgage debt. In typical non-recourse loans a provision called “bad-boy clauses” are part of the loan documents which state that in the event of fraud, intentional misrepresentation, gross negligence, criminal acts, misappropriation of property income, and insurance windfalls, the lender can hold the borrower(s) personally responsible for the debt of the mortgage.

Understandably, in commercial mortgage negotiations the lenders prefer recourse loans where the borrowers would prefer non-recourse loans. In the process of underwriting the lender and borrower(s) work to create a loan that meets both parties need and objectives and if an impasse presents itself – the loan is not issued.

The world of commercial mortgages offers investors the ability to participate in a marketplace that can have attractive yields, principal safety through lien positions on real estate assets, and durations (12 months to 5 years) that are acceptable to most. The creation of ongoing monthly interest through holdings such as Commercial Mortgage Notes is attractive to both consumers and institutional investors.

Commercial Property – What to Do If the Lease Is Unsigned

In commercial property management and leasing you frequently come across the problem of the tenant delaying the signing of the lease. It can be for a number of reasons such as:

  • The complete terms of the lease are still being negotiated
  • The tenant is still finalizing their fitout design
  • The various partnership members are not all available for signature
  • The documentation is still with the tenants solicitor
  • The business or government department is taking time to process the document
  • The decision makers are away
  • Approvals for permitted use are delayed at local council

So the list goes on and you will see many variations of the problem. Tenants will give you so many different reasons why the lease is still outstanding. Frequently the delay process is not as it seems and there are other alternatives that the tenant is adopting for their own reasons. Tenants will not tell you the whole truth; that is a fact.

The signature on a lease is then a critical element of making the tenancy available for occupancy. In almost all lease situations, you would want the tenant to satisfy the following criteria before the keys to the tenancy are handed over:

  1. The lease is totally and correctly signed
  2. The plans and drawings associated with the tenants fitout have been submitted to the landlord and are approved
  3. The plans and drawings associated with the tenants fitout have been submitted to the building control board or local council and are approved
  4. The first months rental is paid in advance in accordance with the lease documentation
  5. The appropriate personal or bank guarantees are provided to the landlord in accordance with the agreement to lease
  6. All associated documentation and disclosures tied to the lease implementation are correctly served and satisfied
  7. The deposit required under the lease agreement or lease arrangement is paid

The golden rule in the leasing a property to a tenant is that all lease requirements are satisfied in accordance with the property managers instructions and the landlord’s requirements before any keys and tenancy access are given.

It should also be said that any incentive to be made available to the tenant as part of the new lease structure should not be released or made available until all the six points above are satisfied.

In most instances with commercial property, the tenants you work with are very experienced in business and negotiation. They are likely to be more experienced than the property manager or the landlord. The tenants will set up the leasing situation to their own advantage during the lease negotiation.

So the clear message here is that the premises should not be handed over to the tenant until all lease documentation requirements have been satisfied correctly and legally.

Commercial Property Managers – Tenant Retention Plans Are Beneficial for the Long Term

As part of a comprehensive commercial property management service, you should be providing a quality tenant retention program and service. In simple terms, the good tenants in a property should be part of a retention strategy, whilst the other weaker tenants should be part of a replacement strategy.

Here are some issues to help you establish a professional tenant retention plan in a managed commercial or retail property.

  1. Review all the competing properties in the local area to understand their vacancy factors, and tenant mix profiles. Look for any strengths and weaknesses in each of those properties. Understand how those properties can relate to the function of your property. Could those properties be attracting your tenants to move? Make sure you understand this fact.
  2. Check out the local municipal council regards upcoming future property developments. Understand if any of those property developments could have impact on the supply and demand ratio for occupied space. If you do have new local property developments coming up, check out the timing of the property release, and the potential rentals that could apply to attract new tenants. Expect that those properties will also offer large incentives as part of the property release strategy. Those properties could soften the effective market rental due to incentives offered.
  3. Review your existing property as to tenancy mix and lease profiles. Identify those leases that will soon to expire. That will normally be leases to expire inside the next two years. Those leases will be of immediate concern given that you will need a strategy to handle the expiry and or tenancy replacement. Planning and preparation is everything.
  4. Split your tenancies in your managed property into desirable and undesirable tenants. It is the desirable tenants that you will be encouraging to remain in occupancy. You will need a standard set of rentals and lease conditions to apply as part of negotiating with existing tenants. You will need to set market rentals that apply to existing tenants. The market rentals that you choose should be carefully considered with regard to recoverable outgoings and property expenses. You may choose gross or net market rentals but in each case the recovery of outgoings needs to be optimized for the landlord.
  5. The undesirable tenants should be identified and monitored as they get closer to the end of their lease. When the expiry of the lease is less than 12 months away, you will need a replacement tenant strategy. That will include target market rental, incentive allowance, landlord works, and permitted use.
  6. If your property contains one or more anchor tenants, pay special attention to the existence of the anchor tenant and how they are interacting with the specialty tenants across the property. A productive and proactive anchor tenant will encourage customers to the property and underpin the rental overall. A good anchor tenant helps the property to be successful.

So these are some of the issues to consider as part of preparing for your tenant retention strategy and tenancy mix plan. The property ownership requirements of the landlord should also be considered in balance to the decisions that you make with regard to leases. The rental for the property will also be set with relevance to the prevailing property market conditions through the local area.

Commercial Property Leasing – Pain Points to Lease Negotiation

When leasing commercial or retail premises there are certain points of negotiation that always create pain for the parties concerned. Here are a few of the big and most common ones:

  1. The landlord wants a high starting rent
  2. The tenant wants a big incentive
  3. The tenant wants a huge option term for further potential occupancy
  4. The landlord wants a tenant but is not prepared to provide an incentive to attract them to the property
  5. The last tenant left the premises in a mess and the landlord will not fix it up until a new tenant is found
  6. The landlord will not refurbish the premises before they have a tenant on a signed lease
  7. The tenant does not want to give any form of guarantee as security in the case of any default of lease

These are the most common problems for the average lease negotiation. Most landlords also think that their property is better than anything else around and on that basis will not negotiate down on any rent to get the premises let. So often you hear that the landlord is prepared to wait it out and see what the next tenant will offer.

In this market there are limited numbers of active tenants looking to relocate to new premises. In some cases there can be 5 properties available for every tenant to choose from. Urgency in the lease deal is not high from the tenant’s perspective; landlords need to know this. They may only get one tenant to make an offer for the premises.

When it comes to leasing premises it is not where you start your lease and rent, but it is more important to know where you are headed and where you will finish. Rent reviews during the lease term can take care of rent escalation to improve the lease, providing the real estate agent negotiates the lease well.

So what can you do with this list of common leasing problems? The best way is to use the pain of the vacancy (in the case of the landlord), or the pain of the need for new premises (in the case of a tenant) to move the deal forward. You should work with the offer that you have and not hope that another will come again soon to replace a low offer today.

Take today’s lease offer and turn it into a valuable lease over the term. Show the landlord the real value of the lease by doing an analysis of the deal using a net present value approach on the lease cash flow over the lease term. It is remarkable how the landlord will soften their negotiation position when long term lease value is explained in numbers.