The Congressional Oversight Committee Panel Report suggests that “a wave of commercial real estate loan failures could threaten America‘s already-weakened financial system.” The report goes on to warn “A significant wave of commercial mortgage defaults would trigger economic damage that could touch the lives of nearly every American.” The panel’s report has some dire predictions of the future of small and medium sized banks across the U.S.
Commercial mortgages are generally built much differently than first time home buyer loans.
Most Americans have limited knowledge about what a commercial mortgage is and why they should be concerned with the report’s findings. First, we will define a commercial property mortgage. Then, we will give an example of what a worst case scenario would look like. Finally, we will look at how this will hurt the economy and the American people and what we ca n do to divert the crisis.
Commercial property is:
A commercial property mortgage has many definitions. For our purposes we will define it as non-farm and non-residential. A residential property can be defined as anything from 1 to 4 units.
How commercial real estate is financed:
A commercial real estate loan is different from a residential mortgage. It takes into account the income generated from the property, as well as the appraised value of the property. A simplistic way of understanding this is: a hot dog stand in Time Square is worth more than a hot dog stand in a town of 300 people.
Scenario of a commercial mortgage:
Let’s say that 10 years ago you purchase a 12 unit office building for 1 million dollars. The bank financed 80% of the loan, and you had to come up with the rest ($200,000).
The term of the loan would look something like this, a 10 year loan for $800,000, simple! But wait, your cash flow from the property will not cover the cost of operating and the mortgage payment. Luckily, the bank came to the rescue. They base the payments on a 30 year loan term. Hurray! Wait, what does that mean? The banker (whispering in your ear), says “you make the payments on the loan like it was a 30 year term, but the loan is only for 10 years, and this lowers the mortgage payment and creates a positive cash flow.” You exclaim (in a loud voice ) “I’ll take it!”
However, it will not give the borrower (you) a chance to reduce the principle (the amount that you borrow). Effectively, you will only be paying the interest, and no principle reduction.
Fast forward 10 years, and it’s time to refinance. So, you go down to the bank to secure a new loan, only to find that it is now a Starbucks. So the search begins for a new lender, only to discover that your property value has dropped by 40%. WOW, can you say upside down? There isn’t a bank around that will finance you without a larger down payment.
So, let’s review the numbers. You borrowed $800,000, paid nothing on the principle, and you will need to pay that loan off before securing new financing. Typically, the old loan would be paid at closing with the funds from the new loan.
What will the new loan look like? The commercial bank will lend you $360,000 and you will need to come up with the rest. How does this happen? The property is now worth $600,000. The banks have tightened up lending standards and will only finance 60% of loan to value. The property has lost 40% of its equity over the past 10 years. So, the property is worth $600,000 (you originally paid 1 million), and 60% of that is $360,000. You eat the rest, $440,000, plus the $200,000 you originally put down, for a grand total of $640,000 thousand dollars.
The report clarifies, “Even borrowers who own profitable properties may be unable to refinance their loans as they face tightened underwriting standards, increased demands for additional investment by borrowers, and restricted credit.” You have to swallow that? No amount of ketchup will make that taste good.
