Have you ever wished you could invest in real estate without spending all your savings? Well, a participation mortgage might be the perfect solution for you.
A participation mortgage allows multiple people or entities to team up and share in real estate investment costs and profits, while also reducing each participant’s risk exposure on a mortgage.
To be clear, reduced risk isn’t no risk. Before you invest, make sure you know and understand the different types of participation mortgages, how they work and the risks involved.
Let’s take a closer look!
What Is a Participation Mortgage and How Does It Work?
A participation mortgage allows multiple parties to pool their money to buy a property.
Normally reserved for large, complex deals between real estate investors, participation mortgages can also be implemented by:
- Friends and family to buy an investment property
- Corporate entities for commercial real estate transactions
- Crowdfunding investment groups that invest together
Participation loans are not exclusive to commercial real estate. They can be used for any asset you want to rent out.
The participants all share in the profits and losses of the investment, and usually each participant is responsible for a portion of the mortgage payments. A participation agreement outlines the terms of a deal and helps ensure all participants are on the same page in terms of their investment goals and financial commitments.
How participation mortgages work
Let’s say you and two entrepreneurially minded friends are interested in purchasing a hot rental building that just hit the market, but none of you can afford to buy the building on your own.
After some thoughtful conversation, brainstorming and market research, you all agree to use a participation mortgage and evenly split the cost of the $3,000,000 building.
All the mortgage details are outlined in the participation agreement – which is usually drafted by an attorney retained by the lead lender, lead borrower or third-party entity overseeing the purchase.
The details include the roles and responsibilities of each participant, like who makes the monthly payments and what happens if someone wants to sell their share. The terms of the participation agreement will be up to you and your two entrepreneurially minded friends.
Each of you put $250,000 down toward the purchase of the rental building, leaving you with a total mortgage of around $1,250,000, not including interest, closing costs and other expenses.
You each own one-third of the property and are responsible for one-third of the monthly mortgage payment. You decide to evenly split any rental income and share equally in the profits and losses when the property is sold.
From conventional to complex
The complexity of a participation mortgage depends on the participants and what is included in the participation agreement.
Let’s say the three participants from our previous example agree one person is responsible for making the monthly mortgage payments, one person is responsible for upkeep and repairs and one person is responsible for marketing and finding new tenants. This helps ensure each participant is contributing to the success of the investment and helping to reduce the risk for everyone involved.
Of course, arrangements can get far more complicated than this example. Participation mortgages tend to be more complex transactions involving numerous real estate investors, such as institutional investors, pension funds or financial institutions, and the deals may include multiple lenders, too.
Repayment terms
Repayment terms are also spelled out in the participation agreement. The various repayment options are:
- Traditional monthly payments that combine principal and interest
- Interest-only repayment plans
- Balloon payment at the end of the loan
It all depends on what the participants have agreed on.
A large lump-sum payment made at the end of a loan’s term, usually in exchange for lower monthly payments over the life of the loan.
Participation mortgages are usually issued by nontraditional lenders (such as entrepreneurs and hard money lenders) because conventional and commercial mortgage lenders typically won’t finance these types of loans.
Participation mortgages are typically considered nontraditional loans because they don’t meet the underwriting standards set by Fannie Mae or Freddie Mac. Since participation loans have more relaxed underwriting standards, nontraditional lenders are often more willing to create flexible repayment options that fit the needs of each participant.
Nonparticipation
When a participant wants to sell their share of a property, it can have different implications for the remaining participants. If the participant that sells wants to cash out completely, the other participants may choose to either buy them out, pay off the mortgage or exercise other options outlined in the participation agreement, such as offering the available share to a new investor.
What Are the Different Types of Participation Mortgages?
A participation mortgage can be set up in three ways: borrower participation, lender-to-lender participation and borrower and lender participation. Let’s take a look at each one.
Borrower participation
Also called participation among borrowers, this can be considered a co-borrower situation. You’re sharing the loan with another person(s) and each of you is responsible for making payments on your share of the loan.
Lender-to-lender participation
Lender-to-lender participation happens when two or more lenders agree to share the funding of a loan and the risk associated with it. The terms of the loan are decided by the lenders, and the borrower(s) pays each lender their share of the loan as outlined in the terms.
Borrower and lender participation
Borrower and lender participation is a mix of the two previous types. In this scenario, both the borrower(s) and the lender(s) share in the risk of the loan. This strategy is often used for large, complex real estate transactions.
What Are the Pros and Cons of a Participation Mortgage?
Here are some things to consider before deciding if this real estate investment strategy is right for you.
✅Get into real estate investing
A participation mortgage can be a great way to get into real estate investing without having to make a large down payment on your own.
✅Lower interest rates
Interest rates tend to be more favorable because there is less risk for the lender when multiple qualified borrowers are involved.
✅Less risk
This type of investment can help spread out the risk associated with real estate investing.
✅Feel more confident
If you’re working with an experienced partner(s), a participation mortgage can generate more confidence in the investment.
⛔Potential strain on a relationship
Investing with family or friends can potentially ruin relationships. Make sure you have a well-written participation agreement in place to help reduce the chances of harming any relationships.
⛔No guarantee of gains
Loss of equity is as much a risk with a participation mortgage as it is with any other type of real estate investment.
⛔Shared control
You’ll need to be comfortable sharing control of the property. You may not have as much control over the property as you would if you were the sole investor.
⛔May be responsible for a participant’s payments
Depending on the terms of the participation agreement, you could be on the hook for more money than you originally agreed to if the other participant(s) can’t make their payments.
Are There Special Considerations With Participation Mortgages?
Every major financial maneuver you make requires extra consideration. Ask yourself these questions if you’re contemplating using a participation mortgage to finance your real estate investment:
Are you comfortable working with the other parties?
Consider expectations and styles of communication and conflict resolution.
Is the equity trade-off worthwhile?
Complete property ownership allows you to benefit 100% from its appreciation and growth in equity. When investing with others, you receive a smaller equity share in the property.
Are you comfortable with the language and terms of the participation agreement?
Clarity is key, and an attorney’s review is essential. The agreement should be clear about your responsibilities and what you should expect from your partners. A well-written participation agreement can help you avoid conflict later on.
Are you prepared for the possibility of losing your investment?
Real estate is a risky business. While a participation mortgage spreads risk across numerous borrowers, you should consider your risk tolerance level.
Going Into Business With Friends and Family: Cause for Pause
A participation mortgage can be a great way to get into real estate investing, but like any type of investment, there are pros and cons to consider. The biggest risk of a participation mortgage may not be a financial one. It may be the risk of mixing friends, family and finances.
A strong participation agreement can help overcome some of these concerns, but it’s important to go into any business venture with your eyes wide open.