Investing in real estate is a big step to make and for some people, financing such an investment means you may have to bring other people on board. For such occasions, there is something called a participation mortgage.
This post will explain what it is, how it works, the pros and cons, associated risks, and the different kinds.
What is a Participation Mortgage?
A participation mortgage is a type of home loan. It allows separate real estate investors to team up and share the income or proceeds from the rental or sale of a piece of the mortgaged property.
A real estate equity participation agreement is generally drawn up between borrowers, lenders, and borrowers, or different lenders.
You can use a participation mortgage to finance the purchase of a commercial property or any other asset you intend to rent out, for example, a boat or vacation apartment.
This type of loan is also known as a profit-participating loan agreement, and it allows participants to reduce their risk and, at the same time, increase their purchasing power. It’s not unusual for loans of this kind to come with a lower participation interest rate, mainly if more than just a couple of lenders are involved in the deal.
A mortgage of this kind is very common in commercial real estate deals. Participation mortgage lenders also tend to be typically non-traditional, such as an entrepreneur who wants to invest in real estate but doesn’t want to deal directly with the maintenance and development of the income properties.
Pension funds also tend to be lenders because this type of investment offers more return than bonds without the volatility of stocks. Investors of this kind are essentially silent partners.
How does a Participation Loan Work?
Participation mortgages used to be very common. Nowadays, you can still find them financed to some degree. With this type of mortgage, two or more parties agree to take on the financial risk of an investment property. In exchange for taking that risk, they get a specified percentage of the return on investment from either the rental or sale of the property.
Different combinations of investors can choose to team up, for example, two or more individual borrowers, borrowers and lenders, or multiple lenders. Each participant gets a share in the equity.
Borrowers choose this type of loan because it increases their purchasing power. Lenders, on the other hand, benefit from reduced risk.
Participation mortgages are common when it comes to commercial real estate investments such as the purchase of apartment complexes or office buildings.
It is usual for the parties to split the NOI, or Net Operating Income. The NOI is the sum of the revenues from the operation, minus any operating costs. Typically, the profit split will be 55/45. In such a case, the lender will receive a lower share.
Regarding repayment terms, these very much depend on the individual lender and the type of participation loan real estate agreement. However, the possibilities are as follows:
- Interest-only payments, which means the monthly payments are often lower in the beginning.
- Principal and interest payments just like a traditional mortgage
- A balloon payment is when the remaining balance is paid at the end of the loan term. Over the life of the loan, the borrowers make low monthly payments then pay a large balloon payment at the end.
Different Types of Participation Mortgage
Participation Among Borrowers
Borrowers usually team up to increase their purchasing power and reduce risk. Regarding financing, each partner becomes an individual mortgagee or borrower on the loan. Generally, the lender will make each borrower individually responsible for the entire loan.
Participation Between Borrower and Lender
Participation between borrower and lender is more common in commercial real estate mortgages. The lender will offer more attractive loan terms in exchange for a share of the proceeds as and when the property is sold. For example, a lender could ask for a participation mortgage if the funding is to purchase an undeveloped commercial property that will be developed and then sold for profit.
Participation Among Lenders
Lender participation is common practice in the world of commercial business lending. There are many reasons why a lender might want to team up with the competition, but the most prominent reasons are the need to diversify and reduce risk.
For lenders, managing their loan portfolios is just as important as it is for investors to manage their investment. Diversification is critical because it helps avoid over-exposure in one particular economic sector or industry.
Having too large a credit facility can easily upset any diversification strategy, which means the lender may decide to recruit partner lenders to share the risk. The problems are similar if a lender has small capital assets. It won’t be possible to lend out enough to keep the loans diversified. Participation loans allow this lender to diversify because it can take small shares in various credit facilities.
Under a participation agreement, the originating lender is known as the lead bank and will be the customer’s primary contact point. If a lender is thinking about bringing in partner lenders, it will inform the customer of its intention during the proposal and negotiation stage.
The Pros and Cons of a Participation Mortgage
This type of arrangement has pros and cons, both for the lender and the borrower. Let’s look at each in turn.
- A lower interest rate is often charged by the lender.
- Borrowers are able to take out a much larger real estate loan than they might have qualified for on their own.
- Several financial institutions can share in the profits.
- The lender’s risk is reduced.
- Investors and financial institutions can diversify their assets.
- When the loan is much larger, there is a more considerable risk of losing money.
- It’s not unusual for lenders to offer their riskier loans for participation, so it’s essential to do your homework first.
What Are The Risks of a Real Estate Equity Participation Agreement?
As with all kinds of legal agreements, there are risks involved. For example, if the loan participation is not correctly structured or documented, unnecessary risks are involved. Knowing what the pitfalls are means all participants can plan for and mitigate such challenges.
Risks for Lead Lenders
- Failing to retain evidence and underwrite properly.
- Failing to follow the contract terms, for example, not obtaining operating statements or forwarding payments.
- The new lines of business or loan products are not covered.
Risks for Purchasing Lenders
- Flexibility and control are lost.
- There are issues with getting timely information.
- The purchasing lenders become overly reliant on the lead lender.
- Risk of loss exposure under liquidation or workout.
Some Things to Consider
From a borrower’s point of view, while a lower interest rate has its apparent benefits, giving up lots of equity can make the deal seem less attractive. However, it does depend on how the agreement is structured.
In some cases, the interest savings could offset the equity loss. Let’s not forget that it does allow the borrower to develop a more substantial property than they would have been able to afford if they had a standard mortgage.
From the lender’s point of view, the problem is monitoring cash flow. One key thing to do is inspect the borrower’s books in order to check the declared net revenues are accurate. In addition, it’s critical to make sure the borrower is not fluffing out their expenses so they can report a lower net income.
Something else to consider is the fact that the borrower or property developer could decide to cut corners on the improvements and safety features. They have to bear the cost of repairs and only get a share of the net income.
Participation loans are particularly attractive for pension funds because they have built-in inflation proofing. Pensions usually include cost-of-living adjustments that rise during times when inflation is high. Real estate prices tend to track inflation, so participation mortgages ensure higher returns on equity when inflation is high.
Participation mortgages come with lots of benefits for both the borrower and the lender. For the borrower, the most significant plus is that the interest rates charged by the lender are usually lower than average. Such low-interest rates often make up for the diminished earnings on the loan with the income revenue stream and future sale revenue.
Looking at participation loans from the borrower’s perspective, they are similar to introductory teaser rates offered with certain mortgages, such as an adjustable-rate mortgage. However, in the case of a participation mortgage, you know the interest rate is going to be low throughout the life of the loan.
This type of loan is beneficial for lenders because it allows them to take some of the profits. But, at the same time, they can cut the amount of risk that is attached to a possible default.
The bottom line is that a participation loan is beneficial for both the lender and the borrower. However, you must do your due diligence first. Read the participation agreement carefully and make sure the cash flow is equally divided between all borrowers.
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