What is 'Participation Mortgage'
A participation mortgage is a type of mortgage that 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.
BREAKING DOWN 'Participation Mortgage'
Participation mortgages are often seen in commercial real estate transactions that anticipate ongoing rental income, such as an office building or apartment complex. In return for a lower interest rate on the loan, a lender will take a share of the net operating income, which is defined as the sum of revenues minus operating expenses. A typical split would be 55/45 with the lender receiving the smaller share. In addition, the lender gets a portion of the resale revenues—often all profits above a certain benchmark, including repayment of the loan principal.
Why a Borrower Would Want a Participation Mortgage
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 the loan with the income revenue stream and the eventual sale revenue. From a borrower’s perspective, participation loans are similar to the introductory “teaser” rates offered with an adjustable rate mortgage (ARM)—except in this case the lower rate is fixed 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 larger property than he might otherwise be able to afford.
The Lender's Perspective
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. Provisions must be made for inspecting the borrower’s books to ensure that declared net revenues are accurate. Otherwise a lender wouldn’t 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.