Market Know-How: Mortgage Lending for the Poor

Commercial mortgages work under the same principles as residential property loans. But, while residential mortgage loans are extended to private individuals, in the case of commercial mortgages the borrower is a legal entity seeking to add a new property to its balance sheet.

That factor aside, the process of developing commercial mortgages today is highly reminiscent of the early stages of the evolution of residential mortgage lending, and hence, all the difficulties that that sector is facing.

From the Rich to the Poor

Mortgages as a means of security for large loans have long been around on the Russian market. Major institutional investors, the European Bank for Reconstruction and Development and the International Finance Corporation, as well as several foreign banks extend loans against real estate property.

The majority of Moscow’s developers actively raise loans for the construction of offices or shopping centers. But the difference between such schemes and mortgage lending is that loans are not extended against the new development but against assets the borrowers already have on their balance sheets.

For example, construction of the second phase of Aurora Business Park is being financed by Raiffeisen. The first completed part of the property has been pledged to the bank as security for the loan.

Azamat Kumykov, investment analyst at Colliers International says: “Banks take an interest, first and foremost in the cash flows generated by pledged property.” When the property in question is a shopping mall or a business center, the creditor attaches importance to the composition of tenants and the stability of cash flows they produce.

“A loan against a vacant building is hard to obtain because the title alone cannot guarantee that the borrower will be able to pay off the debt,” he adds. That is why, he says, “we can only feel sorry for small businesses,” because banks do not view small firms as reliable borrowers.

“The market plays big and taking part in its growth is impossible for small and medium-size companies, as they lack sufficient resources,” explains Oleg Repchenko, head of the IRN.ru think-tank.

Focus on Small Businesses

For years small businesses had no access to mortgage lending simply because they had nothing to offer as security while banks refused to extend loans against the small properties they planned to acquire. Companies resorted to various solutions. Most applied for business development loans or so-called corporate loans, but many rejected that option, frightened off by the extremely high interest rates of 14%.

Denied the opportunity to borrow, small businesses face another serious problem: an inability to expand their properties – both at their own expense and by borrowing. Small companies are forced to rent space from larger companies, which often results in rent growth and disrupts business planning.

Several companies have recently come up with a mortgage lending plan for companies. Two companies in Moscow have publicly announced the launch of just such a service: the consulting firms MainDecision and the Moscow Mortgage Center.

“Our project was launched only six months ago, but we have gone all out to make it possible for small businesses to raise loans against real estate property. Small businesses do not have enough assets because they are small, which is why it is easier for them to pay off the loan than pay rent,” says Sergei Kirpriyanov, head of commercial mortgages at the Moscow Mortgage Center.

MainDecision’s general director, Svetlana Sidorenko says “Nowadays, commercial mortgage lending is at a stage of development that residential mortgage has already passed. Interest rates are rising, there is no secondary market, transactions are complicated, and there is no reserve supply of properties under construction.” But mortgage schemes are likely to become a very effective means of raising additional funding.

Terms of the Deal

Where a company is short of resources and cannot afford to buy the property required, it can apply to the bank for a loan. A potential borrower must meet a number of requirements.

To begin with, the business must be officially registered as a legal entity. Secondly, the company should be able to pay off the initial installment – 35-40% of the loan. If the applicant does not have enough funds he can offer other assets as additional security.

In line with Article 5 of the Law on Hypothec (Mortgage on Real Estate Property), those “other assets” are buildings, installations or other real estate properties used for business purposes.

Furthermore, the borrower must prove his ability to pay the interest on the loan by submitting a financial report. The best proof of creditworthiness is that the company has not gone into the red over the past year. The cost of the transaction also includes a fee to an intermediary (3-5%) and an insurance company (up to 4%).

Svetlana Sidorenko says that “today banks offer loans for a period of up to 3 years on the security of purchased commercial property. The size of the loan does not exceed 50% of the company’s annual balance, with rates of 16% and higher.

Sergei Kipriyanov disagrees. The Moscow Mortgage Center is working jointly with the National Mortgage Bank offering 5-year loans at an annual rate of interest of 12%. That scheme has already been put into practice. “We have already brokered our first commercial mortgage deal for a 120,000-square-meter store in Mitino. Thus, we have tested the scheme and proved that it works,” Sergei Kirpriyanov says.

Immediately, after the deal is signed the purchased property is added to the borrower’s balance, and he assumes all the ensuing obligations, including property tax liability.

However, the scheme has a serious disadvantage, Sidorenko says. It is impossible to carry out any re-planning of the building since it is very difficult to distinguish between re-planning and “damage done to the pledged property”. To obtain permission for raising every new partitioning wall the landlord has to go through a time-consuming and nerve-racking bureaucratic procedure, she says.

A Special Case

Another instrument similar to the commercial mortgage is leasing, launched recently on the market. “A leasing deal can be defined as a backdoor mortgage,” Svetlana Sidorenko says. Under a leasing deal a bank purchases a real estate property and then extends a loan on preferential terms to its affiliate against that property. Thus, the affiliated company, established by the bank itself, becomes a lessor.

That model has been repeatedly tested on the market. For example, the Master Leasing company is affiliated with Master-Bank, Absolut-Credit was established by Absolut Bank, while the United Finance Leasing Company works with Loko-bank.

The borrower, i.e. the lessee, signs a tenancy agreement with the lessor, whereby the former undertakes to pay monthly installments to the latter. After the term of lease expires the lessee takes over the ownership of the building.

The obvious advantage of leasing – as compared to mortgage lending – is that the size of the initial installment, or advance payment, is considerably lower. The borrower can even be freed of those expenses altogether, though such optimal schemes have not yet become very popular in Russia.

Banks offer various schemes each of them with their own advantages and disadvantages. For example, Absolut Bank offers loans at an interest rate of 12%, with an advance payment of 30%, but for a longer term. The Agro-Industrial Group frees its borrowers of advance payments.

The additional advantages of leasing, Svetlana Sidorenko says, are the opportunity of advanced repayment and the absence of any extra charges the borrower could face apart from those explicitly stated in the agreement.

The set of papers the borrower has to submit is restricted to only three documents, including a sale agreement, a title deed and an insurance policy. Insurance protects the lessor and the lessee against a variety of risks, in particular, the risk of losing property, and amounts to approximately 0.1% of the size of the loan. Besides, the lessee can count on tax and depreciation benefits.

Moreover, the borrower is allowed to carry out restructuring work on the property. The plan basically allows small and medium-size companies to purchase properties without having to cope with higher rents. MainDecision receives around 100 leasing applications daily, but only 20% of those are satisfied, Sidorenko says.

Reluctant Banks

For the time being, out of the 48 banks involved in mortgage lending only the National Mortgage Bank has announced its participation in a commercial mortgage program; the majority of Moscow banks say they do not plan to launch such schemes in the foreseeable future.

Their reluctance to get involved in new programs is usually put down to gaps in legislation. However, there are no legal obstacles to the development of commercial mortgages in this country, says Vitaly Mozharovsky, partner with Pepeliaev, Goltsblat & Partners.

“Commercial mortgage lending is even simpler than residential because there is no social element here, no restrictions are imposed on claims to pledged property. Therefore, there should be no difficulties,” he says.

Yuri Borisenko, head of the real estate, land and construction department at the Vegas Lex law firm, agrees with Mozharovsky. “There are no restrictions on claims to mortgaged commercial property, just as there are no problems with regards to the sale or lease thereof,” he says. “The only problem may arise in relations with tenants because after the building is sold off the tenancies remain in force.” If a new landlord decides to sell the property he will have to pay a penalty or come to terms with the tenants somehow.

One of the key reasons that banks are not keen on launching commercial mortgage programs is the high risks involved. First and foremost, this pertains to the size of the loan. “It is one thing to risk $50,000, but risking $0.5 million is quite another matter,” says Svetlana Sidorenko.

Loans at the Moscow Mortgage Center are available on sums starting at $300,000, says Sergei Kipriyanov. Here, the age-old problem of a lack of long-term money arises. “While the development of residential mortgage lending is financed by the government, the commercial mortgages market receives no such support,” Repchenko adds.

Another peculiarity of commercial mortgages is the risk that the loan may end up on the bank’s balance books because there is no market for refinancing loans.

If on the market for residential mortgages there is the Housing Mortgage Lending Agency which buys up mortgage pools from private banks, on the commercial property market there is no such organization.

Furthermore, foreign funds show no interest in such loans. “They take no interest in such purchases, as the schemes and standards of the deals lack transparency as to who valuates the facility, who carries the risks, etc,” says Irina Radchenko.

But the main risk is that the borrower can go insolvent or default on his debt for some reason. “The balance books of legal entities are far from perfect because almost the entire Russian business sphere is semi-legal,” says Radchenko.

Irina Radchenko explains that “the decision to purchase an office property is supposed to be made jointly by all the company shareholders who are often at odds with each other”. As a consequence, the banks face problems with debt recovery and cannot be certain they will ever get their money back.

But, Sergei Kipriyanov says, an effective means of avoiding such risks is insurance. The Moscow Mortgage Center has launched a comprehensive bank insurance program, he reports.

In line with the plan, if a borrower fails to honor his commitments twice, an insurance company covers the debt in full after issuing a formal warning to the borrower and then takes over the rights of the mortgage holder and lender with a right to collect all fines.

The Standard Reserve insurance company has already announced its participation in the program, Sergei Kipriyanov reported.

In all fairness, it should be noted that some market analysts are highly skeptical of the program. “This is either a publicity stunt or the insurance company’s standing is so strong that it does not fear enormous losses. It assumes the underwriting – auditing and debt recovery – and then undertakes to evict the borrower from the property, while the borrower, most likely, has a security service and connections with the courts,” Radchenko notes.

In Search of a Seller

One more serious obstacle impeding the development of commercial mortgage lending is the unwillingness of commercial property sellers to adopt such schemes.

“The bank sets conditions, which often prove largely unacceptable for the seller. For example, the banks often insist that the seller should bear all the risks. But the seller has a number of investors who are ready to buy the property at once. That is why if a retailer applies for a mortgage, he cannot be certain that he will find a seller,” holds Alexander Tishkov, head of the real estate consulting company AM-2 Magazin Magazinov.

Mikhail Gets, head of the commercial real estate department at Blackwood, agrees. “Not all landlords agree to sell on credit; it does not pay because the demand for commercial properties today exceeds supply considerably,” he says.

That is why mortgage brokers offer various solutions for speeding up the transaction and transferring the funds into the seller’s account as early as possible.

To begin with, there is the so-called buy-out of the legal entity where a new legal entity is established – the company that holds the legal title to the property. Afterwards, the borrower buys up the shares in that company, repays the loan and takes over the property. The Moscow Mortgage Center has already brokered one deal under such a scheme, Sergei Kipriyanov says.

Then, there is a multi-stage scheme involving the buyer, the seller and the bank. At first, the buyer pays the initial installment to the seller, while the bank undertakes to cover the remaining sum after the mortgage is registered. After that the mortgage is registered with the bank, and the buyer has his title to the property registered. The parties then sign the sale agreement and the seller receives the total amount

The third scheme is the simplest of all. The parties sign the sale agreement, the seller gets the first installment from the buyer and a bank guarantee, whereupon the buyer registers the title to the property and the mortgage agreement is registered with the bank.

All those methods help speed up the procedure and satisfy the seller, but given the shortage of small properties on the market they are not very effective. “Today only large properties are available. If a property goes on sale, you cannot buy anything smaller than an entire floor in a building. Moreover, builders rarely put up new developments for sale, opting to rent them out instead,” Oleg Repchenko says.

Room for Growth

While banks and sellers are apprehensive about commercial mortgages, the third party – would-be borrowers – are look forward to further development. IRN.ru “would gladly resort to the mortgage scheme to buy a 200-square-meter office,” says Repchenko.

“The company does not have the entire sum but we are ready to pay the first installment of 30% and borrow at an annual interest rate of 12% in rubles,” he says.

Still, the first step has already been made Sergei Kipriyanov is convinced. The Moscow Mortgage Center has already brokered one deal and is currently considering six more applications.

“In particular, we are considering an application for the construction of an oil refinery in Ivanovo Region where the total amount of prospective borrowing stands at some $30 million. There are smaller deals, for $2 million and for $3.6 million. One of the applications is for redeveloped office properties,” Kipriyanov reports.

Repchenko believes that the development of the commercial mortgage market will receive a boost after major operators focus on properties at the Moscow City business center. After that the fight for small business tenants will begin.

“The same has already happened in the housing sector. While prices were growing at an enormous rate, companies ignored private clients. As soon as the prices stopped climbing, they had to boost sales and remembered about mortgages,” he says.

Today, mortgages for small businesses are still rare and the demand exceeds supply. Irina Radchenko says there may be two reasons for that.

To begin with, this is a matter of time. “The banks are only just beginning to work in that field, taking the first steps. So let them accrue experience with residential mortgages first, and then they will switch to corporate clients.” Secondly, “it is necessary to make small and medium-size businesses legal so that their financial reporting is correct and transparent,” she says.