Commercial mortgages

The construction of office buildings, shopping centers, and other commercial structures is generally financed with an instrument known as the commercial mortgage. Short-term mortgage loans are used to finance the construction of commercial projects, while longer-term mortgages are employed to pay off short-term construction loans, purchase land, and cover property development costs. The majority of long-term commercial mortgage loans are made by life insurance companies, savings and loan associations, and pension funds, while commercial banks are the predominant short-term commercial mortgage lender. Banks support the construction of shopping centers, office buildings, and other commercial projects with loans secured by land and building materials. These short-term mortgage credits usually fall due when construction is completed with permanent mortgage financing of the projects then passing to insurance companies, savings and loans, and other long-term lenders.
The growth of commercial mortgages has been quite rapid in recent years, the dollar volume of such loans nearly tripled during the 1970s, rising from about $80 billion to almost $260 billion. However, the market was buffeted by severe problems as the decade of the 80s began. Up to that point, most commercial real estate financing was provided trough fixed-rate mortgages. Faced with rapid inflation and soaring interest rates, however, commercial mortgage lenders began searching for new financial instruments to protect their rates of return. Many mortgage lenders today combine both debt and equity financing in the same credit package. The best-known example is the equity kicker, where the lending institution grants a fixed-rate mortgage but also receives a share of any net earnings from the project. For example, a life insurance company may agree to provide $10 million to finance the construction of an office building. It agrees to accept a 15-year first mortgage loan bearing a 12 percent annual interest rate against the property. However, as a hedge against inflation and higher interest rates, the insurance company may also insist on receiving 10 percent of any net earnings generated from office rentals over 15-year period.
Another device used recently in commercial mortgage financing is indexing. In this case, the annual interest rate on a loan may be tied to the prevailing yields on high-quality U.S. government or public utility bonds of comparable maturity. Lender and borrower may agree to renegotiate the interest rate at certain intervals-every three to five years is common. There is also a trend toward shorter maturity commercial mortgage loans-many as short as five years-with the borrower either paying off the debt or refinancing the unpaid principal with the same or another lending institution.