Commercial loan market - 5 year balloons & interest rate risk

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I wanted to expand on a topic that Joel Owens and I started to discuss on another thread. It relates to the loan offerings available from local/regional banks for commercial loans under 2MM. I know it has been discussed several times however I want to dive into the pros/cons along with other options available in the marketplace. I am definitely concerned about the interest rate risk currently present in my 5 year ballon loans. What will happen to real estate once interest rates start to soar? How will inflation come to affect interest rates and vice versa.

Local/Regional Banks - CRE loans under 2MM

  • Typically fixed for 3 or 5 years. Many come fixed for 3 to 5 years with a ballon payment after the fixed loan period. Some banks will go to 7 years however these are extremely far and few between. I haven't been able to find a bank that will commit to 7 years. Large deposits and prior relationship help however don't always guarantee the ability to get 7 year fixed loans. Banks are scared of the interest rate risk...just about as much as we are.
  • I'm seeing rates ranging from 3.5-5% depending on the market and borrower. My lowest interest rate on CRE loans under 2MM is 4% and I'm currently going through the refi process.
  • Full recourse loans with no exceptions. If you are syndicating deals sub 2MM then your investors with over 20% stake will have to personally guarantee the loan. If they bring the majority of the capital they still might have to guarantee the loan even if they have less than 20% ownership.
  • Low loan fees....sometimes extremely low. We were currently approved for a 1.44MM acquisition and construction loan with loan fees totaling $1,000.
  • Higher LTV - Local banks will go as high as 80% LTV
  • Construction loans - Ability to have a construction loan tied in with the refinance or acquisition loan.
  • Amortization typically at 20 years with some banks going to 25 years.
  • No pre-payment penalties - I'm not seeing pre-payment penalties from local/regional banks on CRE loans.
  • Short closing timeframes - If you have an existing relationship you can close a loan within 30 days depending on the bank.

Small Balance CMBS under 2MM

  • Typically fixed for 10 years (sometimes 7 years)
  • Rates are generally priced around 5.5% (right now) and are based on the swap rate + so many basis points. Or some other pricing structure.
  • Non-recourse - Huge benefit of the loans
  • High loan & inspection fees - Very high loan fees in relation to the loan amount. 20k plus
  • LTV - max LTV is generally around 75%
  • No construction funds available within the loan.
  • Amortization as high as 30 years
  • Pre-payment penalties
  • Longer closing time frames (60 days)

Small Balance Life Insurance under 2MM

  • Similar to small balance CMBS however possibly come with full recourse and lower LTV (70% LTV). Life companies generally want nicer and new product.

So what do you go with? One option is to do bigger deals...3-4MM+ so non-recourse financing makes more sense. Let's table that option though...let's look at the loan options listed. Local/Regional bank loans are relatively cheap when compared to their non-recourse counterparts. They are easy to refinance with no-prepayment penalties. Let's compare two 1MM loans...

Local/Regional Bank example

1MM loan @ 4% for 20 years with a 5 year ballon

Payment is $6,060

Balloon payment due at year 5 of $825,298.

Non-Recourse example

1MM loan @ 5.5% for 30 years with a 10 year ballon

Payment is $5,678

Balloon payment due after 10 years of $831,087

So in this example the balance is actually higher after 10 years on the non-recourse loan compared to the full recourse 5 year balloon bank loan. And that is obviously the case due to the amortization and interest rate difference. The 5 year fixed loan could jump up to 7-8% if interest rates spike. However you have the ability to refinance cheaply at the 5 or 6% range if you see rates skyrocketing up. With the non-recourse option you have to deal with high loan fees and pre-payment penalties but you have 10 years. How important is non-recourse financing to you and your investors? It is probably important to your investors. You might not have any outside investors for a smaller deal like this though. I'm not pro one way or the other...I see benefits to both sides however would like to get the thoughts of other experienced BP members.

Thoughts?


Great topic Chris,

I think the real answer on interest rate risk gets to the core of what you believe economic theory wise.

1. The Keynesian case: aggregate demand is staggering spitting starting. While we see a huge spike in aggregate demand over the next 5 years? The shift away from housing as a driver in the economy leads me to think not so much.

2. The monetarist case: That fed just keeps printing money. We are looking at 77% inflation before you know it.

My bet is more toward case #1. It makes more sense to me based on anecdotal evidence i.e. more in line with the great sociological shift. Of course I am spoofing the monetarist argument because I am a die in the wool Keynesian.

Prudence will of course dictate modeling all scenarios. Hedging options are available but I am not up to speed on the specific techniques to do so.