How scary are balloon payments / short term debt?

12 Replies

Right now I'm in residential 100% because of the availability of 30 year debt. Balloon payments terrify me, am I overreacting?

Not being able to refinance is one of the ways you could lose everything. I can't imagine how scary it would be to have to refinance in a recession. You also have to pay closer attention to interest rates.

Depends on the asset class you are talking about.

With NNN you can find full length term money that runs with the primary lease and zero's out before the option period.

Now you are not going to like the interest rate versus the cap rate spread you are buying at because almost no cash flow will be present in that situation.

So if you are buying a 6.5 cap and 20 year term debt is in the 5's margins will be really small and get decent as rent increase kick in. Now if you are buying at a much higher cap then it doesn't matter as much with the long term debt as you have a bigger spread still.

If you are in an asset class where you believe it has the ability to cap rate compress over the next 12 to 24 months then long term debt might not be the answer. Instead getting a 5 to 10 year loan with a 25 to 30 year amort. might make more sense as you will be selling off and doing a 1031 into the next opportunity whether in that asset class or another that is at the bottom.

It is all situational really on the investors goals and risk tolerance. Most of my clients like the 10 year term loans. The interest rate is still good for the spread and they also get a fair amount of time to knock down the principal balance owed so it offsets interest rate refi risk if they do not want to sell at or around loan maturity.   

An important point to look at is the difference between a balloon on an investment versus a balloon on primary residence.  We will assume that we are talking about investment properties and also that the investment cash flows and made sense to buy in the first place.  If those 2 assumptions are true, then the balloon doesn't have to be scary.

Let's say you have a commercial property consisting of 10-units (apartments, retail, whatever, just think in general terms for now).  You have analyzed the investment and it meets your goals for cashflow and ability to support it's own debt service.  You borrow money on a 20 year amortization with a 10-year balloon.  Let's also assume that there is a rate adjustment built in for year 5, since that is fairly common in commercial lending.

Where we are with interest rates today we may never see again in a life time, rates will likely inch up over the next several years.  Typically, interest rates adjust to curb inflation as the economy starts to improve.  I am not an economist so I am not going to throw out any specific prediction, other than to say they will probably go up.  My uneducated guess would be that in five years they may be up a couple points.

So tackling the rate adjustment first, you should look down the road at a possible rate bump and make sure that your property can support it.  Yes, this will bite into your net income BUT, as @Joel Owens  points out, many commercial leases have rent bumps written in to them.  If you are renting apartments, you may be able to bump rents somewhat to keep up with your increased interest (and other) cost.  This is, very simply, why inflation happens by the way.  In the end, most likely if you are managing your asset well, you won't see much of a change on net income even if the rate bumps a few points.

Now for the balloon.  Let's say you buy a $ 500,000 property and put 20% down, so you are borrowing $ 400,000 on a property that we will assume was in a stable market and really worth the purchase price you paid when you bought it.  Your Loan to Value is 80%.  Let's assume that the market remains stable and that there is no real appreciation in value.  Let's also assume so I have some numbers to plug that there is no rate adjustment in year 5 and that you borrowed the money 20/10 at 5.8% interest.  I'm doing this to simplify the analysis, so bear with me.  Fast forward 9 1/2 years and you start to panic over the balloon.  Check out these numbers:

You have paid $ 2,819.76 every month on time for the last 9.5 years.  Your lender contacts you, or you contact your lender, and you learn that they have chosen NOT to renew the mortgage for another 10 years.  As an aside, they MAY choose to renew at a new rate and you may decide to do so.  For my example, though, we are assuming the worse case and they are calling the debt due.  To keep our analysis easy, I am going to also assume that you have to refinance and do so exactly at year 10, so you have made 120 payments.

So, at the end of the 10th year, your principal balance is approximately $ 256,298. Assuming still, no appreciation in property value, your LTV is now just over 51% due to the loan amortization. My bet is that if your payment history is good, the asset has been maintained, and there are no major red flags, you will have no problem AT LEAST refinancing the principal balance remaining. It is also quite possible that you will not only be able to finance the principal balance, but you may also take cash out and walk away with cash in hand to put into another investment. You will then have leveraged your equity to use for even more investments.

Carefully managed financing doesn't have to be scary.   Understanding it helps.  Many of our loans are commercial.  Closing costs can be higher than residential loans.  However, being able to cash out offers a lot of options.  Keep in mind that banks WANT to lend money.  A mortgage held by a bank is an ASSET on their balance sheet that creates a return, in the form of interest.  They don't want too much cash sitting idle.  If you present them with a fair risk (you pay your bills, the asset/property is stable and well managed, etc.), they will want to lend money to you now and also later when your balloon is due.

Loans from a bank are typically the 5/5 mentioned if they go out 10 years. Usually it will say year 5 the rate adjusts to prime at the time plus 100 points or something.

Now if you are doing a bank loan you try to push for a ceiling on the rate when year six comes. The bank will push back but sometimes you can get them to agree. The benefit with these types of loans is there usually is no pre-pay attached to the loan. The downside is there is recourse but you try to get that limited or taken off once a certain LTV is reached.

The debt my clients put on larger commercial property is typically non-bank lenders ( CMBS, life insurance companies, etc.)

Typical deal for CMBS now is a 10 year term ( not 5/5 like banks ) fixed in the 4's and you get a 30 year amortization with non-recourse. There is even an option for interest only the first 2 years of the loan for about 300 basis points higher cash flow.

The insurance companies are more picky on the property and they like low LTV's in the 50's to 60's and 35 to 45% down versus the 25% a CMBS will take. For insurance the loan rate is better and they will give out longer loan terms.

So it's really about the property and what lenders want and then matching that up to the goals of the investor buyer as much as possible. Sometimes what the investor wants for a particular property just isn't going to happen for a multitude of reasons.

 @Adam Johnson

 @Joel Owens  

So you have 50% equity after ten years. But year ten there is a bad recession. Values fall by 50%. The property is in sore shape, with numerous vacancies. Commercial bank lending is skittish. Maybe even your other properties aren't doing so well either. So you have no equity, a bad lending environment and the property is in worse shape than you bought it. The chances of this happening over a 20-30 year investment career isn't rare either. 

Meanwhile, a residential owner knows what he pays every month ($853 for me). I will pay this exact amount for 30 years (unless I refinance by choice). 

As I said there is 15,20 year fixed debt out there the question is will you except the fixed rate hike for that additional PERCEIVED security??

Houses can lose value too and rents can fall. 

Commercial the value is tied to income of the property, lease guarantor, and cap rates.

You can take any property, in any asset class, and find a reason not to purchase it.

At the end of the day your money is yours and you decide what to do with it. Other investors it's their capital and they decide what is a good purchase to them. I can't stand residential and don't want it.

Everyone is different which makes the world go round. You can have houses fall to short sales and foreclosures and then the new owners with a lower buy price reduce rents in the marketplace. The values go down and the rents go down as well and I have seen that happen. 

Originally posted by @Alex Silang :
 @Adam Johnson

 @Joel Owens  

So you have 50% equity after ten years. But year ten there is a bad recession. Values fall by 50%. The property is in sore shape, with numerous vacancies. Commercial bank lending is skittish. Maybe even your other properties aren't doing so well either. So you have no equity, a bad lending environment and the property is in worse shape than you bought it. The chances of this happening over a 20-30 year investment career isn't rare either. 

Meanwhile, a residential owner knows what he pays every month ($853 for me). I will pay this exact amount for 30 years (unless I refinance by choice). 

Not sure where you're getting this idea from, but even during the last recession which saw some of the highest RE price drops ever, prices were not at 50% levels from 10 years prior.  There was a build up to overvaluation then a correction in varying amounts depending on your location.  So a $500K rental property in 1998 was not worth $250K in 2008 unless you did something terribly wrong over that 10 year period or maybe bought in an area that had other problems beyond the economy (maybe Detroit for example).

Buying in the wrong location is a whole different issue...but even during the recession you'd have no problem finding a bank to lend 50% LTV on an asset with a 10 year history of performance.

You're being way too conservative in your assumptions here. There are certainly other micro/macro things to consider, but a 5 or 10 year ARM isn't a valid reason to stay away from 5+ unit multis or other assets that you can't get 30 year fixed loans on.

Originally posted by @Michael Seeker :
You're being way too conservative in your assumptions here.  There are certainly other micro/macro things to consider, but a 5 or 10 year ARM isn't a valid reason to stay away from 5+ unit multis or other assets that you can't get 30 year fixed loans on.

Your explanation is what I was looking for. Thanks to everyone else who posted as well. 

Originally posted by @Adam Johnson :

An important point to look at is the difference between a balloon on an investment versus a balloon on primary residence.  We will assume that we are talking about investment properties and also that the investment cash flows and made sense to buy in the first place.  If those 2 assumptions are true, then the balloon doesn't have to be scary.

Let's say you have a commercial property consisting of 10-units (apartments, retail, whatever, just think in general terms for now).  You have analyzed the investment and it meets your goals for cashflow and ability to support it's own debt service.  You borrow money on a 20 year amortization with a 10-year balloon.  Let's also assume that there is a rate adjustment built in for year 5, since that is fairly common in commercial lending.

Where we are with interest rates today we may never see again in a life time, rates will likely inch up over the next several years.  Typically, interest rates adjust to curb inflation as the economy starts to improve.  I am not an economist so I am not going to throw out any specific prediction, other than to say they will probably go up.  My uneducated guess would be that in five years they may be up a couple points.

So tackling the rate adjustment first, you should look down the road at a possible rate bump and make sure that your property can support it.  Yes, this will bite into your net income BUT, as @Joel Owens  points out, many commercial leases have rent bumps written in to them.  If you are renting apartments, you may be able to bump rents somewhat to keep up with your increased interest (and other) cost.  This is, very simply, why inflation happens by the way.  In the end, most likely if you are managing your asset well, you won't see much of a change on net income even if the rate bumps a few points.

Now for the balloon.  Let's say you buy a $ 500,000 property and put 20% down, so you are borrowing $ 400,000 on a property that we will assume was in a stable market and really worth the purchase price you paid when you bought it.  Your Loan to Value is 80%.  Let's assume that the market remains stable and that there is no real appreciation in value.  Let's also assume so I have some numbers to plug that there is no rate adjustment in year 5 and that you borrowed the money 20/10 at 5.8% interest.  I'm doing this to simplify the analysis, so bear with me.  Fast forward 9 1/2 years and you start to panic over the balloon.  Check out these numbers:

You have paid $ 2,819.76 every month on time for the last 9.5 years.  Your lender contacts you, or you contact your lender, and you learn that they have chosen NOT to renew the mortgage for another 10 years.  As an aside, they MAY choose to renew at a new rate and you may decide to do so.  For my example, though, we are assuming the worse case and they are calling the debt due.  To keep our analysis easy, I am going to also assume that you have to refinance and do so exactly at year 10, so you have made 120 payments.

So, at the end of the 10th year, your principal balance is approximately $ 256,298. Assuming still, no appreciation in property value, your LTV is now just over 51% due to the loan amortization. My bet is that if your payment history is good, the asset has been maintained, and there are no major red flags, you will have no problem AT LEAST refinancing the principal balance remaining. It is also quite possible that you will not only be able to finance the principal balance, but you may also take cash out and walk away with cash in hand to put into another investment. You will then have leveraged your equity to use for even more investments.

Carefully managed financing doesn't have to be scary.   Understanding it helps.  Many of our loans are commercial.  Closing costs can be higher than residential loans.  However, being able to cash out offers a lot of options.  Keep in mind that banks WANT to lend money.  A mortgage held by a bank is an ASSET on their balance sheet that creates a return, in the form of interest.  They don't want too much cash sitting idle.  If you present them with a fair risk (you pay your bills, the asset/property is stable and well managed, etc.), they will want to lend money to you now and also later when your balloon is due.

@Joel Owens

Say you have a triple net strip center with the primary tenant having 5 years remaining. It seems that getting debt to match the term of the lease is no problem, but what about going beyond that? Would it be possible to get 10 year debt with a personal guarantee from a borrower with liquidity of several times the size of the loan (despite only 5 years remaining on the tenant? Not to mention that after 5 years, the property will be close to 50% LTV (based on initial price). Of course, the lender assumes the tenant moves out for their underwriting and property value drops significantly so it's no longer a true 50% LTV after 5 years.

Thanks

Originally posted by @Alex Silang :
 @Adam Johnson

 @Joel Owens  

So you have 50% equity after ten years. But year ten there is a bad recession. Values fall by 50%. The property is in sore shape, with numerous vacancies. Commercial bank lending is skittish. Maybe even your other properties aren't doing so well either. So you have no equity, a bad lending environment and the property is in worse shape than you bought it. The chances of this happening over a 20-30 year investment career isn't rare either. 

Meanwhile, a residential owner knows what he pays every month ($853 for me). I will pay this exact amount for 30 years (unless I refinance by choice). 

 Well if you've run the property into the ground by letting it get into poor condition with high vacancy what did you do to win in this situation?    The balloon is not the reason for failure in that situation, it's poor management of the asset by the owner.  

Strip center is underwritten differently from a loan standpoint than free standing single triple net building.

For retail strip tenants a 2 to 3 year primary term lease is standard and some go out 5 years before the options kick in.

CMBS lender will go ten years typically on a center. With multiple tenants you have breakeven occupancy in your favor versus a one tenant building going dark.

You want staggering of the leases. So if you have 10 tenants you want say 2 in one year, 1 in another, 2 in another so that you do not have all tenants in the center coming up at once.

If one tenant is large in the center the lender might require heavier escrowing or reserves for TI's and LC's for the future. If's it's a very large center then co-tenant anchor clauses come into play. The larger tenant you would need to see if they disclose sales, their credit rating, if the lease is guaranteed by all stores or just a subsidiary, is there another location more optimal they can move to, are current rent rates in the leases above market, average, below, etc.

Lot's and lot's of factors go into it but if you do it everyday they can be mitigated for the most part when buying and planning exits.

     

@Adam Johnson :

Nice post but I have a question.

You state that banks want to lend money and based on your reasonable assumptions, it should not be an issue to refinance after 10 years.

If so, why would the original lender choose to call the loan at balloon time as opposed to re upping?

Originally posted by @Rob Golob :

@Adam Johnson:

Nice post but I have a question.

You state that banks want to lend money and based on your reasonable assumptions, it should not be an issue to refinance after 10 years.

If so, why would the original lender choose to call the loan at balloon time as opposed to re upping?

 There are many reasons this may happen, so my list would be only a few examples.  The lender may have lost it's appetite for a certain asset class, the lender may have been bought out by another bank and they no longer offer the same financing and/or underwriting, the loan balance may have been paid down too low, other asset classes may have improved and become more attractive for the lender to put money into, regulatory requirements may have changed, etc, etc.  There are many variables.

With that said, continuing to manage the asset properly makes it much easier to place the debt with another lender, should the balloon get called.  As with everything, nothing is guaranteed, but setting yourself up to succeed makes it much easier to cope with bumps in the road.

Join the Largest Real Estate Investing Community

Basic membership is free, forever.

By signing up, you indicate that you agree to the BiggerPockets Terms & Conditions.