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Valuation of participating mortgage interests.

Participating mortgages can be relatively simple instruments or highly complex ones. Their common characteristic is the mortgagee's exchange of a guaranteed return for uncertain future benefits that are based on the performance of the underlying real estate. The deterioration of local real estate markets throughout the nation has generally meant that those instruments have produced lower yields. Nonetheless, a well-structured participating mortgage can maximize overall yield without exposing the mortgagee to inordinate risk.


Participating mortgages are not new the real estate market, though their popularity grew considerably during the rising markets of the late 1970s and mid-1980s because mortgage originators attempted to achieve yields unavailable from conventional structures that specified fixed or indexed interest payments. Insurance companies and pension funds historically have been the most active participants in these investments, because they can invest large amounts of equity and can carry a property through unprofitable periods in order to realize potentially large future profits. During the 1980s, a decade of liberal lending, savings and loans and, to a smaller degree, banks entered into participating mortgage arrangements. However, their general lack of success in this area--brought on by poorly crafted loan agreements or unrealistic expectations of income, combined with the more rigid capital requirements of the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA)--has curtailed if not stopped bank and thrift investments in participating mortgages.

Conceptually, both the mortgagee and mortgagor expect to derive special benefits from a participating mortgage. The mortgagee is able to share in the property's income generation and its potential appreciation, leaving ownership and management in the hands of a professional real estate organization. The mortgagor, meanwhile, usually is required to contribute no or modest equity, and it may also enjoy debt service payments below those of conventional mortgages. Developers and lenders find participating mortgage arrangements particularly beneficial in periods of high interest rates, when traditional leverage is infeasible.

At a minimum, a participating mortgage features a guaranteed fixed or indexed periodic payment that is superior to other claims against net operating income (NOI); additional terms are a matter of negotiation between the mortgagor and mortgagee. The party that receives a superior or subordinate position in the residual income and the recourse the lender has in case of default depend on the relative negotiating strengths of the parties.

The lender's participating interest may take the form of a share of the income stream, subordinated only to the debt service. However, a borrower of particular creditworthiness or expertise or one who contributes substantial equity, may be able to negotiate a preferred return superior to the lender's participation. In more complex instruments, there are often numerous strata of participations in the income stream.

Usually, the lender is provided with an additional interest in some major event regarding the property--for example, its sale, refinancing, or debt retirement. The lender may receive a share of the net reversionary proceeds or a fixed payment predicated on a predetermined formula, depending on the nature of the event. Whether any of the borrower's share of the reversion is superior to the lender's is purely a matter of negotiation.

Guaranteed returns: participation and risk

As previously noted, the lender in a participating mortgage exchanges a guaranteed return for potentially greater future returns. As a reward for relinquishing a portion of its interest, the mortgagor is usually granted a lower coupon interest rate on the mortgage. This arrangement presupposes a positive return on equity. Today, many properties are unable to service basic debt on conventional terms, much less contribute to the accumulation of equity. Therefore, the potential for superior mortgagee profits in a participating mortgage is accompanied by the obverse possibility of inferior or even negative returns.

Although participating mortgages hold the promise of positive returns on future income and appreciation, it is increasingly clear that most lenders would have been better served, at least for the near term, if they had required a higher guaranteed interest payment and foregone the equity participation on loans originated after the early 1980s. Of course, the future may bring rising income or handsome net reversionary proceeds that may offset today's cash shortfalls.


The valuation of a participating mortgage requires the analysis of uncertain future events affecting income. Therefore, the emphasis of the appraisal of participating mortgage interests is placed on the discounted cash flow (DCF) analysis. The appraiser must undertake all the analytical steps required to estimate NOI that the income capitalization approach requires, including thorough analysis of the subject's competitive position in the market: current and future income, expense and occupancy levels, and investors' requirements regarding capitalization rates and long-term yields. Even relatively minor changes in assumptions regarding a property's future performance can have a profound effect on the residual portion of the income stream that is the basis for the mortgage investor's participation.

A participating mortgage is considered a debt instrument because it is a debt obligation secured by a recorded mortgage or a deed of trust. However, the portion of the benefits that does not carry a guaranteed payment has characteristics of an equity interest. The higher loan-to-value ratio typical of participating mortgages essentially transfers equity from the borrower to the lender. The lender's greater risk because of its equity position entails greater required returns and hence more severe discounting of this portion of the income stream for purposes of valuation.

The selection of the appropriate discount rate depends primarily on the individual investor's relative position in the participation. Preferred positions warrant lower discount rates than interests that are subordinate to the preferred interests. The actual discount rate selected depends on the specific nature of the participating mortgage agreement.

A case example in the valuation of a participating mortgage interest

The following example is based on an actual participating mortgage on an existing office building that was operating at a stabilized level, though its rentals reflected the conditions of the overbuilt market in which it was located. The instrument appraised was a new participating mortgage. Its basic terms are summarized in Table 1.

Exhibit 1 shows that the mortgagee's incentives were threefold: a preferred return of 1% per year on the original loan balance that is superior to all other claims against the residual income, a 50% share of the residual income (after deduction of a 9% equity return to the borrower), and 50% of the reversion. These preferences limited the mortgagee's financial risk. Consequently, the lender agreed to an annual coupon rate of 8.81% (a rate below the prevailing conventional financing rate) and a comparatively high 92% loan-to-value ratio.

A survey of active lenders indicated that medium- to long-term fixed-rate office building mortgages at the time of the appraisal were being financed at about 10.25% interest with 75% to 80% loan-to-value ratios. In the same market, however, quoted interest rates on the debt-service portion of participating mortgages, in which mortgagor and mortgagee shared equally in post-debt service cash flow, were about 100 to 150 basis points below conventional mortgage rates.

Sensitivity analysis of NOI assumptions

The valuation of the participating mortgage was undertaken in conjunction with an appraisal of the underlying property. The appraiser's analyst indicated that NOI throughout the investment term should increase at approximately 5% per year, a growth rate compatible with long-term inflationary trends. But bearing in mind the lessons of recent years, the appraiser tested the effects of four TABULAR DATA OMITTED differing NOI scenarios concerning the future income of the property on the internal rate of return (IRR) and the estimated market value of the participating mortgage. The scenarios were the following:
Scenario 1 5% NOI growth per
Scenario 2 3% NOI growth per
Scenario 3 Variable NOI growth as
 * 0% NOI growth in
 years 1-3
 * 5% growth in year 4
 * 10% growth in year 5
 * 15% growth in year 6
 * 5% annual growth
Scenario 4 Some NOI decline plus
 varying growth as
 * 10% NOI decline in
 year 1
 * 5% decline in year 2
 * No growth in years 3
 and 4
 * 5% growth in year 5
 * 10% growth in year 6
 * 20% growth in year 7
 * 5% annual growth

Scenarios 1 and 2 assume that the property's income-producing potential will continue to increase at level rates. Scenario 3 recognizes the presence of troubled current market conditions and their effect on income but is reasonably optimistic about the prospects for recovery. Scenario 4 is a pessimistic scenario, calling for actual income declines in early years and deferring recovery for a number of years in the future.

The appraiser took on the task of calculating the present value of the mortgagee's interest under the assumptions of each of these scenarios. In Exhibits 1, 2, 3, and 4, the appraiser calculated the flow of the various components of the income stream, including debt service and all participating interests, over the projected 13-year term of the mortgage. (No attempt was made to measure the return to the mortgagor, only to the mortgagee.)

The appraiser's analysis led to the conclusion that properties similar in age and quality to the subject would probably trade at a terminal overall rate of 8.5%. The TABULAR DATA OMITTED appraiser applied this capitalization rate to NOI in the fourteenth year of the income stream and established a reversionary value. After deducting sales expenses of 3% of the reversion, the appraiser divided the net proceeds equally between mortgagee and mortgagor to produce line 7 in each exhibit, Mortgagee's Proceeds from Reversion.

Derivation of discount rates

The appraiser calculated a separate discount rate for each component of the mortgagee's income stream. In selecting a discount rate for the debt-service portion of the income stream, the appraiser reviewed lenders' yield expectations for participating mortgages and analyzed the specific structure of the mortgage. Considering the amount of equity that the borrower provided and the mortgage's preference features, the appraiser selected a discount rate of 9%. This rate was about 125 basis points below prevailing conventional mortgage interest rates but in line with quoted rates on participating mortgages at the time of the appraisal.

The mortgagee's preferred return is superior to all claims against the income stream, other than debt service. However, it is earned only if there is positive cash flow after debt service. Consequently, the appraiser selected a discount rate for this portion of the income stream that is higher than the debt-service rate but, because of the preferred position of this interest, well below pure equity yields. Given the structure of the preferred return and its relatively senior position in the income stream, it was reasonable to assume that the implied discount rate was at the level of conventional commercial mortgage rates, which at the date of the appraisal was approximately 10.25%. The appraiser used this rate to discount the mortgagee's preferred return.

Valuing the mortgagee's participation required the appraiser to select an appropriate equity yield rate, a return that an investor would require to take a position subordinate to other, superior claims against the income stream. The appraiser concluded that because of the considerable risk of such a subordinated position, an annual rate of return of at least 17% would be required to attract capital to such an investment. This rate was used to discount the residual portion of the income stream, which is the basis of the mortgagee's participation. The present value of the mortgagee's total interest at reversion is given in line 11 of each of the four exhibits.

Finally, Exhibits l, 2, 3, and 4 calculate the mortgagee's IRR from the investment. In each exhibit, Line 9 is the net cash flow to the mortgagee, including the initial debt and all proceeds from debt retirement and reversion at the termination of the investment. The IRR to the mortgagee's position may be calculated from this line.


The yield and market value indications produced by the four different scenarios are summarized as follows:
 Market Value
 Mortgagee's Indicated
 Interest IRR
Scenario 1 $44 million 12.1%
Scenario 2 $41.9 million 10.9%
Scenario 3 $43.2 million 11.8%
Scenario 4 $41.5 milion 10.9%

Although the assumptions regarding future income were quite divergent, the difference between the highest and lowest value indications ($2.5 million) represents only about 6% of the lowest value estimate. Therefore, this particular mortgage seems to provide good protection to the mortgagee against a short period of declining market conditions. Even the lowest value indication is well above the present mortgage balance of $39 million, TABULAR DATA OMITTED largely because of the contribution of the participation income.

The appraiser's assumptions were those of Scenario 1. The other scenarios merely tested the sensitivity of the market value of the investment to variant market conditions. These tests are useful from an investment analysis perspective in measuring the risk and reward characteristics of the mortgage.

Although the indicated values of the alternative scenarios appear to support the credibility of the investment, the two most pessimistic scenarios raise questions regarding the borrower's financial strength. The borrower must cover significant cash shortfalls for four to seven years, after having placed more than 8% equity into the transaction. Unless there are additional funds in escrow or the borrower has an exceptionally strong balance sheet, the lender should be concerned about both the borrower's ability and willingness to withstand these losses until the property returns to a profitable position.

In the two most optimistic scenarios, the mortgagee's investment produced IRRs of 11.8% and 12.1%. These yields compare favorably with total expected returns on comparable office buildings at the time of the appraisal. However, the two pessimistic scenarios each result in IRRs of 10.9%, well below total expected yields. Although 10.9% is somewhat greater than prevailing conventional mortgage rates, the mortgagee is compelled to question whether it is sufficiently greater to offset the risk of the investment. Under conventional mortgage terms, the borrower would have contributed a much larger proportion of equity, which would have offered more protection to the mortgagee in the event of a loan default or devaluation of the underlying real estate. In the more pessimistic scenarios, the question is not whether there should be conventional or participating financing but whether the loan should be made at all.

The cash flow results illustrate the volatility of residual income as opposed to income from debt service. In all scenarios, the yield from debt service is fixed at approximately 8.8%. In the pessimistic cases, the residual income accounts for 19% of the total yield, whereas it contributes 27% of total yield under the most aggressive income-growth scenario. Whether this is an appropriate balance depends on the objectives of the mortgagee. Clearly, if the mortgagee has a high level of confidence in future appreciation TABULAR DATA OMITTED TABULAR DATA OMITTED and it is able to accept the risk, it may be to the investor's advantage to structure the participation mortgage so as to increase its share of residual income. If the mortgagee has less confidence in the borrower or the investment, a different structure may be warranted.

Stephen T. Crosson is chairman and chief executive officer at Crosson Dannis, Inc., in Dallas, a full-service real estate appraisal and consulting firm.

David L. Clark is a senior analyst at National Valuation Consultants in Denver.
COPYRIGHT 1992 The Appraisal Institute
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Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Author:Crosson, Stephen T.; Clark, David L.
Publication:Appraisal Journal
Date:Oct 1, 1992
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