Participation Mortgage

A participation mortgage is a type of mortgage which allows the lender to share in part of the income, or resale proceeds, of a property. As such the lender becomes an equity partner in the purchase, rather than just a mortgage issuer. In return for a lower interest rate on loan, a lender will take a share of the net operating income (NOI).

Participation mortgages, often seen in commercial real estate transactions, anticipate ongoing rental income. Commercial property include office buildings or apartment complex. The parties will split the net operating income which is the sum of revenues from the operation of the property minus the operating expenses. A typical profit split would be 55/45, with the lender receiving the smaller share. Also, the lender gets a portion of the resale revenues, often all profits above a specific benchmark, including repayment of the loan principal.

The advantage of a participation mortgage to a borrower is the lower interest rate demanded by the lender, who makes up for diminished earnings on loan with the income revenue stream and the future sale revenue. From a borrower’s perspective, participation loans are similar to the introductory teaser rates offered with an adjustable rate mortgage (ARM). The difference is the low rate is stable over the life of the loan.

Of course, the borrower is giving up a lot of equity in return for that lower rate. But depending on how the deal is structured, the interest savings could well offset the loss of equity. In the near term, it could make it possible for the borrower to develop a more substantial property than he might otherwise be able to afford.

Issuers of participation mortgages are often non-traditional lenders. They could be entrepreneurs looking for real estate investments without the hassle of developing or maintaining properties themselves; participation mortgages allow them to be silent partners. Sometimes the lenders are pension funds looking for quality investments that return more than bonds but don’t have the volatility of stocks.

A particular appeal for pension funds is the built-in inflation proofing of participation mortgages. Most pensions include cost-of-living adjustments (COLA) that increase payouts during inflationary times. Since real estate prices generally track inflation,  participation mortgages ensure higher returns on equity during periods of inflation.

A consideration for lenders is the problem of monitoring cash flow. They must inspect the borrower’s books to ensure that declared net revenues are accurate. Otherwise, a lender would not know if the developer was padding expenses to report lower net income. Moreover, a developer could cut corners on improvements or even safety features, since he bears the cost of all repairs but only gets a share of net income, a form of moral hazard.