What is a Commercial Mortgage

What is a Commercial Mortgage

The simplest definition of a commercial mortgage is basically this: a
loan for the purchase or refinance of a commercial property. A commercial mortgage is similar to a residential mortgage, except the collateral is a commercial building, not residential.1 However, to fully
appreciate the complexity and broad use of the phrase, it is best to
first separate the two words and define them independently.

Mortgage Defined

Most people think that a mortgage is the same as a loan and often
use these words interchangeably without realizing the difference.
The terms mortgage and loan have the same meaning in a colloquial
sense, but, technically speaking, the two are not the same thing. A
mortgage is actually a written legal document, referred to as a mortgage instrument, signed by a borrower who pledges his or her title to
the property as security for the loan.
2 In other words, a mortgage is a
written pledge by the borrower to the lender relinquishing the borrower’s interest in the title to the property in the event of a default of
the loan. The term “loan,” on the other hand, refers to nothing more
than borrowed money. The legal term for a mortgage lender is mortgagee, while the legal term for a borrower is mortgagor.
There are generally two types of mortgage instruments: mortgages and deeds of trust.
3 Both instruments create a lien against the title
to the property and represent only a transfer of the borrower’s ownership interest in the property either to a trustee or to a lender; neither is a transfer of the title itself. A lien is a legal claim of one person upon the property of another person to secure the payment of a
debt or the satisfaction of an obligation.4 In layman’s terms, it is the
right to take another’s property if a debt is not paid in full. Not all
states use mortgages. For example, both California and Texas use a
deed of trust to create liens, while other states, including North
Carolina and Georgia, use mortgages. Bear in mind we are talking
about the type of mortgage instrument here. For example, just because
Texas and California use a deed of trust doesn’t mean that the lender
is not creating a mortgage, as previously defined; it’s just that different states have different names for the “mortgage instrument” itself.
States that use either a mortgage or a deed of trust are called
“Lien Theory” states, meaning that both mortgage instruments create a lien against the title to the property rather than transferring title
An Introduction to Commercial Real Estate Loans 3
to the lender. Though both mortgage instruments create liens in the
same way, it is the foreclosure process that sets them apart. A deed
of trust differs from a mortgage in that in many states the property
can be foreclosed on by a nonjudicial sale held by the trustee.5 A nonjudicial sale means that the trustee on behalf of the lender can go
straight to the courthouse steps and conduct a foreclosure sale of the
property without permission from any court. The foreclosure process
can be much faster for a deed of trust than for a mortgage.
Foreclosure processes that involve a mortgage almost always require
court approval before a lender can proceed with the sale of the property to satisfy the debt.6 It is also much more time consuming and
costly to foreclose on a property using mortgages.
States that allow the lender to actually possess or hold title to the
property until the loan is paid in full under the old English common
law system are called “Title Theory” states. The best example to
explain the concept of Title Theory is a car loan. When a person buys
a car, the lender actually holds the original title until the loan is paid
in full and then returns the original paper title to the owner stamped
“paid in full.” There are only six states that still use the old English
common law type of mortgage: Connecticut, Maine, New
Hampshire, North Carolina, Rhode Island, and Vermont. In “Lien
Theory” states, title to the property is actually held by the borrower
for the benefit of the trustee and the lender until there is a default
under the loan. In the event of a default, the trustee then forecloses
on the lien on behalf of the lender.
Mortgages are created only for real estate, which is why mortgages and deeds of trust are recorded in the real property records of
county courthouses. You will never hear a car loan, a business loan,
a personal loan, or any kind of non–real estate debt referred to as a
mortgage. Mortgages today are exclusively used for both residential
and commercial real estate loans, which may explain why the home
loan industry and residential brokerage firms prefer to use the word
4 Commercial Mortgages 101
“mortgage” rather than the word “loan.” Despite what may have
become natural for you to say, teach yourself to start thinking like a
professional and begin associating the word “mortgage” with the
words “lien” and “deed of trust.” In summary, if you really like using
the term “commercial mortgage” because it is natural or easy to say,
always remember that what you are really describing is a commercial
real estate loan

Commercial Defined

If you look up the word “commercial” in the dictionary, you will find
that there are many definitions, depending on the context of the
usage. But what is crystal clear is that the word has no association
with real estate in any way. “Commercial” is derived from the root
word “commerce,” which has more to do with trade and business
than with real estate. So what does the word “commercial” really
mean when it is associated with mortgage or real estate? In the context of this book, the word “commercial” can be best defined as meaning “not residential.” Residential properties, as defined by Fannie Mae,
are limited to single-family homes and multifamily dwellings of four
units or fewer, such as duplexes, triplexes, and fourplexes. It is
because of this very narrow definition that we find the word “commercial” convenient, because if the property is not a single-family
home, a duplex, a triplex, or even a fourplex, what other alternative
do we have but to classify it as commercial?
So up to this point we can safely say what a commercial property is not. What then is a commercial property? As long as it doesn’t
meet the Fannie Mae definition of a residential property, a commercial property can be any type of building or parcel of land used for
any commercial purpose. In other words, if it is not a
single-family home, a duplex, a triplex, or a fourplex, then it is simply a commercial property. Why is this significant? It’s important
An Introduction to Commercial Real Estate Loans 5
because commercial properties and commercial mortgages are as
vast as the oceans that separate the continents, and this is where residential mortgage brokers and novice real estate investors underestimate the complexity of the industry. Unlike the residential mortgage
industry, which is largely regulated by Fannie Mae, the commercial
mortgage industry is fragmented and extremely inconsistent.
Commercial properties and commercial mortgages can be simple or
extremely complex, depending on the property type.
Not all commercial properties are alike. There are a variety of
income-producing and non-income-producing properties that qualify for loans and some that do not. Whether or not a particular commercial property type qualifies for a loan also depends largely on the
type of lender. This is why it’s best to first become familiar with the
many types of commercial properties and their subsets. Lenders can
be very fickle, and you will learn quickly that not all commercial
lenders like the same kind of commercial properties. Some lenders
will lend only for apartments, while others will lend only for office
buildings, so it’s critical that you understand how to identify a commercial property and properly describe it to the lender. If you don’t
know what kind of commercial property it is or what it is used for,
you will soon lose your credibility with the lender and possibly the
lender’s interest altogether.
Typically, a commercial building is the lender’s only collateral
or security for the repayment of a commercial real estate loan. The
type, condition, age, size, and quality of the commercial building
must be described in detail for the lender’s consideration. You may
think that’s easy to do. After all, there’s no difference between a
retail center and a shopping center; they’re all the same anyway,
right? No, they’re not. For example, there are many variations
of shopping centers, such as grocery-anchored centers,
non-grocery-anchored centers (also referred to as strip retail centers),
shadowed anchored centers, neighborhood shopping centers, com6 Commercial Mortgages 101
munity shopping centers, big-box power centers, shopping malls,
and single-tenant and high-end specialty or boutique centers.
Lenders actually apply different interest rates and financing terms
according to the type of retail center. For example, interest rates are
usually lower for a grocery-anchored shopping center than they are
for a small strip retail center. This is why broad knowledge of the different types of retail centers is important; it can mean the difference
between a high interest rate and a low one. There are hundreds of
types of commercial properties too numerous to mention, but what
we can do is highlight those commercial property types that are most
commonly sought after by commercial real estate lenders.

Types of Commercial Properties

Commercial real estate lenders make loans on real estate for one and
only one compelling reason: because there is cash flow from the property to pay back the loan. However, not all commercial properties generate cash flow. For example, an unused or unoccupied vacant tract of
land does not generate cash flow though it is still called a commercial
property. Because cash flow is essential with any loan, the collateral
(land and buildings) must first be identified as either a property that
generates cash flow or one that does not. Commercial properties that
generate cash flow are referred to as income producing, and properties
that do not are referred to as non-income producing, or owner-occupied.
Understanding this distinction between income-producing and nonincome-producing properties is key in establishing the foundation on
which the commercial real estate lending industry is built.

Non-Income-Producing Properties

The term “non-income-producing” specifically refers to the absence
of a lease. In other words, the property is not rented or leased to a
An Introduction to Commercial Real Estate Loans 7
person or business, and the commonly assumed relationship between
landlord and tenant does not exist. A tract of land with or without a
commercial building on it whose owner is not receiving rent or any
other consideration is simply referred to as a “non-income-producing
property.” Another term for “non-income-producing” is “owneroccupied,” which means that the company or business occupying the
land or commercial building happens to be the owner of the land and
building as well as the owner of the business. In this situation, the
business owner is relying on the income from the business to pay his
or her commercial mortgage payments to the lender and not to a
landlord. A business owner who occupies his or her property for the
sole purpose of owning and operating a business is simply referred
to as an owner-occupant.
Owner-occupied buildings are free-standing single-occupant
buildings that are occupied by the property owner. These buildings
are usually designed and built specifically for the type of business the
owner is running. For example, a muffler shop is built with equipment intended specifically to lift automobiles up off the ground so
that a mechanic can fix and replace mufflers; an automatic car-wash
facility is specifically designed and built to wash cars. Both buildings
are commercial properties, but they are owner occupied and do not
have any cash flow from rents because there are no tenants. The only
cash flow associated with the property is from the operation of the
business itself, such as income from customers’ payments for parts
and labor for the muffler repair or the income from washing cars.
Owner-occupied properties have neither a landlord nor tenant. There
are small business owners that are owner-occupants, and there are
large companies that are owner-occupants, such as Wal-Mart and
Target. These large retail companies do not pay rent because they typically own their own buildings. Examples of other non-income-producing properties that may or may not be owner-occupied include
the following:

What is a Commercial Mortgage

Income-Producing Properties The term

The term “income-producing” specifically refers to the presence of
a lease. In other words, there is a landlord-and-tenant relationship
in which the owner of the property (the landlord) leases the property to a tenant. The phrase “income-producing,” from the perspective
of a lender, suggests that the cash flow used to pay back the loan will
be derived from monthly rent paid by the tenant to the landlord. The
landlord, in turn, takes the money that he or she receives from the
tenant and uses it to pay back the loan.
It is important to emphasize that the owner of the property (the
landlord) owns the property for no reason other than to make money
by leasing the property to business owners who are interested in only
renting and not owning. Notice the mutually exclusive benefit
between landlord and tenant. Landlords don’t want to own and operate a business, and business owners (tenants) don’t want to own and
take care of a building. The landlord’s expertise is in owning and
operating commercial real estate, not the businesses that occupy
their buildings. Likewise, tenants can focus on running their business without the worry of maintaining and operating a building.
Commercial real estate lenders, like landlords, are experts in
understanding the commercial real estate market and thus are willing to loan money to a landlord. What commercial real estate lenders
don’t understand and prefer not to loan money for are the very businesses that occupy the buildings. Why? The reason is that business
An Introduction to Commercial Real Estate Loans 9
cash flow is a hundred times more difficult to understand. The practice of lending to businesses is an entirely different industry and
often left to bankers who specialize in commercial and industrial
loans. Commercial real estate, on the other hand, in the eyes of the
commercial real estate lender, is a commodity that is easier to analyze and much more predictable.
Commercial properties that are designed and built specifically
to be occupied by businesses that are unrelated to the landlord
are referred to as “investment properties.” Landlords buy incomeproducing properties as an investment because of the anticipated
positive cash flows and capital appreciation. These positive cash
flows are supposed to represent both a return of capital and a return
on capital to the landlord. It is for this somewhat predictable cash
flow that lenders desire to loan money to landlords. Commercial real
estate lenders that try to loan money to owner-occupied commercial
properties must be able to understand the business and what it is
that the business does to generate revenue to ensure that the loan
can be repaid, which is very difficult. Unlike the income-producing
property, the owner-occupied property has as its only source of cash
flow the profit of the business, not the rent. If the lender can’t understand the business, then it is less likely to loan money for the building. There are lenders that lend to these types of commercial properties, but not nearly as many as the number of lenders that desire to
lend on income-producing properties.

Single Tenant Properties

Income-producing commercial properties can be either single-tenant
or multitenant properties. In the lexicon of commercial real estate,
the term “single-tenant” always refers to a landlord-and-tenant relationship, even though it may appear that the building is owneroccupied.
10 Commercial Mortgages 101
Single-tenant properties are solitary free-standing structures,
built on single parcels of land. Most single-tenant properties have
long-term leases because of the specialized use and design of the
property. These properties are usually leased prior to their construction and are rarely built based on speculation. A developer will
agree to develop the site or construct the building in exchange for a
long-term lease with the tenant. You probably have seen those signs
posted on vacant tracts of land that read “Build to Suit.” What that
means is that the owner of the land, usually a developer, desires to
build a structure specifically for an end-user who agrees to lease the
property from the developer for a specified amount of time, say ten
to twenty years. The developer will spend his or her own money to
construct the building and then will lease it to the user. Rarely will
a developer build a single-occupant building without having first
entered into a contract with a specific user who agrees to rent the
property after construction. This is the only scenario in which a
lender will give the developer the construction loan. Unless a developer has more than enough cash sitting in the lender’s vault to cover
the loan, a typical lender will rarely loan money for the construction
of a speculative building. Examples of income-producing singletenant properties include the following:


Multitenant Properties

Multitenant properties usually are occupied by two or more tenants
with shorter term leases, lasting two, three, or five years. Multitenant
An Introduction to Commercial Real Estate Loans 11
properties are considered to be much more flexible than singletenant buildings because they are designed to provide a variety of
store spaces and sizes in proximity to large anchor tenants. Large
anchor tenants like Krogers serve as a major draw for other smaller
tenants. Tenants have specific space and visibility requirements, and
if the building doesn’t have what the tenant is looking for, the tenant
will go elsewhere.
The advantage that a multitenant building has over a single-tenant building is that there is less risk associated with the disruption of
cash flow in the event of an unexpected vacancy. Having two or three
tenant vacancies in a multitenant building is not all that unusual.
The same does not hold true for single-tenant properties. Whenever
a single-tenant property loses a tenant, the property becomes 100
percent vacant, resulting in zero cash flow.
Another advantage of a multitenant property is that its economic life span is much longer than that of single-tenant property.
Multitenant buildings are adaptable to ever-changing retail trends,
unlike single-tenant buildings, which are designed specifically to
meet a tenant’s need at that time. Circuit City and Mervyns are examples of single-tenant buildings designed for a specific retail use that
were closed and are now sitting empty.
Both single-tenant and multitenant properties have their inherent risks, but lenders usually deal with those potential risks in their
underwriting and make adjustments to compensate themselves for
the risks. For example, lenders usually limit the amortization period
of a single-tenant property to a maximum of twenty years if the tenant’s primary lease term is only five or ten years. The reason for a
shorter amortization is that the lender wants the loan paid down as
quickly as possible because there’s no guarantee that the tenant will
be in business ten or fifteen years down the road. Finding a replacement tenant for a single-tenant or special-use building takes a long
time and therefore presents a greater risk to the lender. However, this
12 Commercial Mortgages 101
is not the case for multitenant buildings. Loans for multitenant
buildings often have amortization periods up to thirty years because
of their versatility and longer economic life.
There are many types of multitenant properties, but they are usually differentiated among their own classification. Commercial properties are generally divided into six classifications, with further subclassifications. This is the standard used by commercial real estate
lenders when quoting and pricing a loan. With regard to classification, single-tenant buildings are actually treated as a subclassification
within each of the six general classifications. The six general classifications of commercial properties, along with their subclassifications,
are as follows:

  • Retail
    Grocery-anchored shopping center
    Strip center (unanchored)
    Community center
    Neighborhood center
    Big-box power center
    Regional mall
    Single-tenant
  • Office
    High-rise (downtown)
    Midrise (suburban)
    Medical office building
    Single-tenant
  • Multifamily (apartment)
    High-rise
    Midrise
    Garden-style
    An Introduction to Commercial Real Estate Loans 13
    Condominium
    Mobile home park
  • Industrial-warehouse
    Office warehouse
    Office-flex
    Self-storage/mini-warehouse
    Light manufacturing
    Distribution facility
  • Hospitality (hotel and motel)
    Full-service
    Limited-service
    Extended-stay
    Resort
  • Special purpose
    Senior/independent living
    Assisted living
    Skilled nursing facility
    R&D (research and development)

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