In the months following the beginning of the COVID-19 pandemic, commercial mortgage delinquency rates were positioned to follow a similar trend to the pre-2008 market crash. Fortunately, many measurements show these delinquency rates to be stabilized.
But with continued economic challenges related to supply chain issues, the military conflict in Ukraine and lingering consumer uncertainty, commercial mortgage lenders and borrowers remain at risk in the current financial environment. This risk can be tied to a key component of traditional commercial lending: personal assets being used as collateral for mortgages.
Adding an investment-grade insurance policy is superior to even the highest-rated personal credit alone.
While traditional, this is no longer the only option. Lenders and borrowers can elect to use commercial loan insurance (CLI) as a substitute for — or supplement to — personal guarantees. Commercial mortgage brokers can build trust by educating their clients on the CLI product, benefiting them through the knowledge that they can preserve savings and assets in the long run by opting for insurance. Typically, brokers also can secure better rates or loan terms for clients who purchase CLI policies.
According to economic data from the Federal Reserve Bank of St. Louis, the delinquency rate for single-family residential mortgages held by banks was 2.13% as of first-quarter 2022. While this figure is lower than pre-pandemic rates, delinquencies are no longer dropping as dramatically as they did from 2012 to 2020.
Although it may seem counterintuitive to track residential delinquency rates, commercial mortgage lenders use this data as a barometer for personal guarantee stability when relying on traditional collateral for commercial loans. Why does this matter to business-purpose lenders? The simple answer is that if a borrower defaults on their personal residence, there also is a good chance that they’ll default on their commercial mortgage – or vice versa.
While commercial loan delinquencies through banks are currently at a rate of 0.78%, near their low point seen in Fed data going back to 1991, the pandemic did cause an uptick. In 2020, delinquency rates rose above 1% for the first time since 2015.
This pandemic-driven increase has since stabilized, but mortgage lenders, brokers and borrowers should still prepare for continued post-pandemic economic challenges. Even in the most successful times, each party involved in a commercial real estate deal should be invested in preserving their money and assets.
To best protect assets they’re lending against, financial institutions should adopt commercial loan insurance as a substitute for the various personal guarantees in a typical business-purpose loan. CLI acts similarly to private mortgage insurance (PMI) in residential lending. CLI, however, is an insurance product that indemnifies a borrower against loss up to the policy amount. The policy is typically for the same amount as any personal guarantee required by the lender, thus doubling the security (if a full guarantee is still needed) and adding an investment grade-rated policy to backstop the loan.
Another unique value proposition of CLI is that, unlike PMI for residential mortgages, a commercial borrower can purchase CLI to use in conjunction with a full or modified personal guarantee. This combination of traditional and modern collateral provides significant benefits to both parties in relation to risk transfer, economic benefit and the ability to do more deals at scale.
The primary benefits of CLI are twofold, with benefits for both lenders and borrowers. For the lender, leveraging this type of insurance means it can protect its investments and better scale the number of commercial mortgages it offers.
Additionally, it provides financial protection to the lender without pursuing the outdated approach of collecting a borrower’s personal guarantee. It can provide added liquidity for a borrower, should it be needed, and is superior to having entry-level guarantors that support multiple projects. In these situations, one problem can trickle down and create more.
For borrowers, the risk is transferred from personal collateral to an insurance policy. Borrowers are more likely to avoid bankruptcy — and the potential loss of personal property — if they default on the loan.
While it’s ideal for commercial mortgage lenders to adopt this type of insurance product, there may be some hesitancy to roll out a CLI program. Additionally, due to the natural risk aversion of financial institutions, especially traditional banks, a risk assessment and rollout could take a significant amount of time. An alternative approach is to encourage the borrower to take out a CLI policy on their own.
Borrowers who proactively take this approach to their loan not only realize the benefits outlined above but also can prove to lenders that they are a less risky investment, which may improve the loan terms. When a borrower opts to purchase CLI outside of lender requirements, this should be considered as an added benefit to the overall loan.
Instead of risking financial ruin if the business fails or payments are unable to be made, the borrower has made a proactive decision to protect both themselves and the lender. Borrowers who invest in CLI of their own accord indicate a sense of financial responsibility unparalleled to noninsured borrowers.
Adding an investment-grade insurance policy is superior to even the highest-rated personal credit alone, and it acts as a true credit enhancement if added to a modified personal guarantee. A typical modification might involve a lower rate due to stronger credit, or a release from financial covenants (which are meaningful to borrowers but toothless for many lenders, even if a lender agrees that they add liquidity to a deal).
The economic benefit to a borrower through a slightly lower rate and the release of financial covenants more than offsets the cost of the policy — often significantly. Taking a modern approach to commercial mortgage security benefits both lenders and borrowers, protecting investments and assets for both parties while providing a more profitable approach to commercial lending. ●