What Is a Participation Mortgage?
The term participation mortgage refers to a type of home loan that allows different parties to team up and share in any income or proceeds that result from the rental or sale of a piece of a mortgaged property. Agreements may include partnerships between borrowers, between borrowers and lenders, or among different lenders.
Participation mortgages reduce the risk to participants and allow them to increase their purchasing power. Many of these mortgages, therefore, tend to come with lower interest rates, especially when multiple lenders are also involved.
- A participation mortgage is shared between several borrowers who also split income or proceeds generated from renting or selling the property.
- These mortgages are most common in commercial real estate deals.
- Lenders of participation mortgages are typically non-traditional, such as entrepreneurs who want real estate investments without having to directly develop or maintain properties.
- Participation mortgages can reduce default risk, resulting in lower interest rates.
How Participation Mortgages Work
Once common in the past, participation mortgages are still financed to some degree. They involve two or more parties who agree to take on the risk of financing a piece of property in exchange for a certain percentage of the profits that result from its rental or sale.
As noted above, two or more borrowers may decide to team up in this type of loan. In other cases, borrowers and lenders, or multiple lenders may team up to share in the equity. These types of loans give borrowers more purchasing power and also cuts down the risk of default to lenders.
Participation mortgages are often used in commercial real estate transactions, such as the purchase of office buildings and apartment complexes, which anticipate ongoing rental income.
The parties involved normally split the net operating income (NOI)—the sum of revenues from the operation of the property minus any operating expenses. A typical profit split would be 55/45, with the lender receiving the smaller share. The lender gets a portion of the resale revenues—often all the profits above a specific benchmark, including repayment of the loan principal.
You can use a participation mortgage to finance the purchase of a commercial property or another asset that you intend to rent out, such as a boat.
Repayment terms for participation mortgages vary based on the lender and the type of agreement. Some may require interest-only payments. In other cases, the borrower(s) may be required to pay both principal and interest payments—just like a traditional mortgage. There are some cases, though, where lenders require a balloon payment. This is when the remaining balance is paid at the end of the loan.
Issuers of participation mortgages are often non-traditional lenders. They may be entrepreneurs looking for real estate investments without the hassle of developing or maintaining properties themselves. In other cases, these lenders may be pension funds looking for quality investments that return more than bonds but don’t have the volatility of stocks. By taking part in this type of agreement, these investors effectively act as silent partners.
Borrowers give up a lot of equity in return for a lower rate by a lender in a participation mortgage. 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 they might otherwise be able to afford.
A consideration for lenders is the problem of monitoring cash flow. They must inspect the borrower’s books to ensure that any 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.
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.
Advantages of Participation Mortgages
The advantage of a participation mortgage to a borrower is the lower interest rate charged by a lender. This makes up for diminished earnings on the 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, though, is that the low rate is stable over the life of the loan. Because they're able to take part in the profits, lenders are also able to cut down the amount of risk that stems from any possible default.