When you have a new business with little or no credit history, it can be nearly impossible to obtain a commercial mortgage. Especially in today's tight credit environment. Still, when you look around any main street in any town in the country, you will see many "For Sale" signs on plenty of commercial properties. It's a great time to be making commercial real estate investments.
This could be the right time to break out an old favorite creative financing tool. A wrap around mortgage can be the best answer when lenders won't make a loan to a new business. With a wrap around mortgage, you take out a new mortgage with the commercial property seller as the lender.
How a Wrap Around Protects the Seller
Often sellers prefer wrap around mortgages instead of installment payments because the seller's name remains on the first mortgage and title. It's less risk for them because they will be the first to know if the buyer stops making the monthly payment. If that happens, they can elect to continue making the first mortgage payment while foreclosing on the buyer with the wrap around mortgage. This prevents late fees and foreclosure costs from piling up while the seller works to regain control of the property.
Wrap around mortgages on commercial real estate investments are a little different from residential properties. This is due mainly to the fact that commercial mortgages almost always contain covenants. These are clauses in the original mortgage requiring certain things to be done in order to keep the mortgage viable. For instance, a multimillion dollar commercial mortgage may require the business to maintain a certain level of profitability or the mortgage can be called in full. Or the first mortgage may contain a covenant that tenant vacancy rates must remain above a certain level or the lender has the right to assume some level of control over the property.
For those reasons, the wrap around mortgage needs to mirror the first mortgage. It's essential that all provisions and covenants of the original mortgage pass through to the buyer by being fully documented in the wrap around mortgage.
More Benefits and Prtection for the Seller
The seller in a wrap around mortgage will insist that the buyer obtain his or her own financing at some time in the future. Typically, this is within 2 to 5 years. If the buyer doesn't refinance by the time the wrap around mortgage calls for, there will typically be penalties that kick in to motivate the buyer to refinance. Often this will be an increase in the interest rate that goes up periodically until the loan is refinanced and the original loan as well as the wrap mortgage are repaid in full.
Another item to make sure is in the wrap around mortgage is a balloon payment. Commercial loans are not for 30 years the way residential loans are. They will have a balloon payment that comes due in 5 years, 7 years, or 10 years. At that time, the original loan must be refinanced. The wrap around mortgage must contain a provision addressing this as well.
A wrap around mortgage is old school creative financing but it's still around because it works and has definite advantages.
Here is a key point you need to come away with. Before entering into a wrap around mortgage as either a seller or buyer, be sure you understand the legal technicalities. Rules and regulations vary from state to state. Know what applies in your state. It also important that all parties to the transaction understand how a specific wrap around mortgage affects them. This is a good time to have a competent real estate attorney involved.
Once you fully understand it, a wraparound mortgage can be an excellent way to make commercial real estate investments with little business credit history.
Author bio: Brian Kline has been investing in real estate for more than 30 years and writing about real estate investing for seven years. He also draws upon 25 plus years of business experience including 12 years as a manager at Boeing Aircraft Company. Brian currently lives at Lake Cushman, Washington. A vacation destination, a few short miles from a national forest in the Olympic Mountains with the Pacific Ocean a couple of miles in the opposite direction.