What is a participating mortgage?

The normal mortgage works very simply. The lender lends and takes a lien (almost always a first lien) against a real asset, typically lending between 60-75% of the purchase price of the asset. In return, the lender receives its money back with interest over a period of time (loan term) and based on an agreed upon payment schedule (amortization schedule).

Being in a first lien position, and limiting the loan to a maximum of 60-75% (sometimes even lower), puts the lender in a very protected position. If the borrower sells the asset at a loss, the lender will not lose money unless the loss is significant. Only drastic swings in property value could put the lender’s principal at risk.

But because of this, the lender does not stand to profit greatly from an individual transaction. The lender will never take more than its interest as profit. All profits from the increased value of an asset go to the borrower. His/her only obligation to the lender is the return of principal and the interest that accrued throughout the hold period of the asset. Nothing more.

In comes a unique financial vehicle called the “participating mortgage.”

There are some lenders (in my experience they are either very large banks or life insurance companies) that would like to participate in potential profits of an asset they lend on. These lenders want their interest to be paid, but they’d also like to participate in profits in a case where the asset was sold for a large gain.

How would they do so? Is it even possible?

It’s possible, but the loan would need to be structured differently. For the lender to participate in profits from the opportunity, they’d need to expose themselves to more risk. No borrower would let the average lender participate in profits when there are thousands of other lenders who’d lend without any profit participation.

Therefore, participating mortgages will typically exceed the 65-75% leverage limit. Such lenders may lend as high as 97% of the cost of a transaction, and in return for increasing their position in the transaction, they’d expect a sizeable chunk of profits.

Here’s the structure one bank shared with me for their participating mortgage product:

  • Leverage amount: 95% of cost
  • Interest rate: 4-6%
  • Cashflow participation: 50% of cashflows to lender after interest is paid
  • Sale Participation: 50% of sale proceeds after lender and borrower both repaid their initial contribution

In this case, the lender is providing the borrower with almost all of the funds for the transaction. In doing so, they earn a nice piece of the profits. But don’t be fooled. This product is not very expensive. Considering that the typical investor in a transaction would look to take between 70-80% of the profits, the 50% this lender seeks is a steal (for the borrower).

That’s why, in my experience, I’ve seen borrowers bend over backwards to get such a lender to work with them. It’s not easy. These lenders are selective, and they sure know how many great operators are seeking their money, so they only work with the best. And only on the best deals.

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