Scenario:

You're an investor who wants to buy for cash flow. You plan on holding the property forever. You buy a self storage property for $1,000,000 at a 9.25% cap rate. You put down 20% ($200,000), so the loan principal amount is $800,000. The annual interest rate is 5.85% and the amortization period is 30 years. You have 5 years until the balloon payment.

This leaves the monthly payment at: $4,719.53

Total monthly payments: $283,171.80

Total Amount Paid: $1,026,213.62

Total Interest: $226,213.62

Balloon Payment: $743,041.82

Though it would be tight, you would be able to pay the monthly payment of $4,719.53 since the NOI is $92,500. This would leave $2,988.80 per month in cash flow, but how would you have enough money to pay the balloon payment in 5 years? Would this deal even make sense?

You refinance into another loan at that point. You don't pay the balloon in cash. You should also implement some value add in there so you have more coming in, and when you refi you have a higher valuation. You can potentially pull out your original capital or more.

@Taylor L.

Okay that makes sense. If you don't mind answering, what would be an example of a loan you would refinance into at that point? 

Assuming you didn't have a value add and it was just a constant 9.25% cap rate. Would you still be able to pay the next loan off in a decent amount of time and also have some cash flow?

Thanks for you reply!

@Ben Bymaster shoot, you could refi into a loan of the same terms if you wanted. You'd have to shop around to see what loan terms you can get. I can't say I've ever run a straight paydown scenario. You're probably leaving a lot of money on the table by not doing value add. Remember that every dollar you increase the NOI is capitalized, so $100 in NOI is over $1k on your property's value.
If you're buying an underperforming self storage facility it's important that you improve systems and processes the old ownership had in place. It's potentially very out of date and inefficient. The most responsible move is to come in and operate it better than they did!
Don't just buy on cap rate.

@Taylor L.

Oh ok, thanks for clearing that up for me. I appreciate the response!

@Ben Bymaster yes get the same kind of loan in 5 years as you started with. You just start the process over again. Often your current lender will simply extend the loan with an adjusted rate.

The bank does this to reduce the interest rate risk. That puts that risk on you and you need to be prepared to deal with it. See if you can negotiate that the bank will not call the loan in 5 years but just adjust the rate. 

@Ned Carey

Thanks for the advice! 

"That puts that risk on you and you need to be prepared to deal with it." Assuming that I was able to keep the occupancy rate steady and the NOI stays relatively similar, wouldn't I be good to go risk wise? Or do you just mean if something drastic were to happen to the property and I wasn't able to pay the loan?

Thanks again for your response.

@Ben Bymaster what if interest rates jump to 12% in the next 5 years? You might not be able to refinance. After the crash of 2008 lots of banks called loans. Sometimes these loans were being paid on time. The banks, sometimes forced by regulators, simply stopped lending and property owners lost their properties.

This is not likely but it is a possibility and recent history is proof.

One way to reduce your risk is make sure you are doing good underwriting of good deals. You can use a shorter amortization period which will mean you have less to refinance when the time comes. You can also  make sure your loans have a high debt service coverage ration. 

@Ned Carey

Oh okay, I didn't even think about that, so thanks for the advice.

I have purchased 44 pads in mobile home parks using seller financing with balloons. Here's what my exit strategies are - Option 1. Do a cash-out refinance after 5 years. You would have enough money to pull out of the deal through the refinance if you added value throughout the years. For example, you bought the property at $1 mil, and you increased the NOI through raising rents, filling vacancies, and lowering expenses. These activities increased the value to $3 million. When you refinance, your lender allows for a 70% LTV and that means you get to pull out 70%*$3 million - mortgage amount. You use this cash to pay off the balloon. You can only do this if you have created value or the market is appreciating like this. It would be hard otherwise. Option 2. You sell the property and the numbers work the same way as refinancing.

I would recommend you negotiating for a longer balloon period. One of my deals has a 5% interest rate with a 10-year balloon term, leaving me plenty time to turn the property around. 

@Jingwen Dunford

Thanks for your input, it seems like you're killing it.

What would you do if for some reason you couldn't add any value, but the property does have decent cash flow from the start? Assuming you couldn't pull a lot of money out but you can make the payments aside from the large balloon payment. Would you just negotiate with the bank to refinance into a non balloon payment loan?

@Ben Bymaster Thanks! If you would like a non balloon payment loan, that means you want the loan to be fully amortized. You could try to get a loan with a shorter amortization period which increases the monthly payment. But if your property has good cash flow to cover the payment, then that would be the best option. Some lenders don't have an option for a longer period loans. So shop around.