Managing Interest Rate Risk

10 Replies

Nearly all of my rentals are financed with commercial loans that balloon in 7 years. I have a very good interest rate of 4.75% and with a 25 year amortization. All of these loans will balloon around the same time as I just recently refinanced two of the buildings and will be closing on another one later in the month. I've generally purchased properties that had the potential to generate additional NOI and I've managed them such that I've forced quite a bit of equity, however, my main focus is cash flow. My concern is what level interest rates may be at 7 years from now and the best way I can manage that risk. My thought is just to pay down the mortgages as much as I can. Commercial loans are a fact of life if you play in this space. How are you guys managing interest rate risk associated with them? Also, how much do you think interest rates will rise? It seems to me that there's a hard limit on how far they can rise without tanking the entire economy given the level of public and private debt as well as the impact on financial markets. I realize that the Fed doesn't control all of that however.

The first thing you do is anticipate what the max impact is if the interest hits the max, and prepare for that when you buy the property.

Since that ship has sailed, one option is to pay down the principle, but that defeats the purpose of cash flow.

You say all your loans are commercial, and they have to be for some reason.  Is that because these are commercial rentals?

You need to time your refinances to stagger the balloon dates/years.

What I would do, if I were in this spot, is to time your next refi to include taking out some of that built up equity.  If you are looking at paying  higher in interest you might just as well get something out of it, and...

this way, you can use the cash out funds to pay down the next loan coming due.  This way, your tenants are still the ones paying off the loans...not you.

Repeat this one at a time for each loan.

All of my properties are  mixed use or multi-family over 5 units, thus the commercial mortgages.  I just refinanced two at the same time two months ago and am closing on another in a couple of weeks, so I had no opportunity to stagger, so 7 years out, they'll balloon at the same time.  I don't need the income as much now but plan on retiring within the same time frame.  I'm thinking my best bet is to pay them down as much as I can.  

@Greg L. You can always refinance early and pull your equity out of properties to either pay off the balloon OR acquire more properties which can help in paying off your existing properties faster. 

IMO, you should be focused on managing the properties efficiently and getting market rent. The interest rate should not be as much of a worry (assuming you're not crazy leveraged). 

@Greg L.

Good ideas from both Joe and Omar.   Here in Canada, both commercial and residential mortgage have terms less than 10yrs ... the most common being 5-years, so "balloons" and renewals are the norm.

As Omar indicated your primary concern should be running your business as efficiently as you can and maximizing the revenue stream.    If you have no better use for a potion of your free cash flow, you could focus on paying down your mortgages.    If you go this route, I would focus on a single property - the one which is costing you the most in interest and/or the one which will yield the biggest free cash flow once paid down - until you reach any prepayment limits imposed by your financing terms.

Additionally, if you are able to switch your payments to {accelerated} bi-weekly (26-payments a year) from monthly, that alone will trim your amortization and total cost of borrowing.

Another thing I frequently do is to take-on variable rate financing on a property (which is usually at a lower interest rate than a fixed rate loan ... by as much as a 1 pt), but set my payment as though I have a fixed rate loan. This may not work as well for you as variable rate real estate notes in the U.S.A. are not as attractive as those here (unless there is something other than an ARM which I have yet to encounter).

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I would also look into getting a portfolio lender, or a smaller bank who will hold it on their balance sheet. They will typically give you longer term. Be willing to move your operating accounts and some long term savings to them as well. They are providing a good/great service to you, I would try to return the favor this way.

Thanks all. Maximizing the NOI remains a huge focus, so thanks for emphasizing that again. My credit union is holding these loans on their balance sheet but the longest term I can get is 7 years. There's another local credit union who will give a 10 year lock, but the interest rate is about 100 bp over what I'm paying now. My credit union has done well by me on rates and terms, but have personal and business guarantees from me. I have another business that has accounts with them as well as personal savings.

If/ once you have a strong 2 year history on the books you can look at longer term fixed rate commercial loan options if your loan size is high enough. Rates don't really have much room to go down and the Fed has announced they are going to raise rates the next few times they meet.

@Greg L. I used to worry about interest rate risk a lot but don't so much these days despite having millions of dollars in variable rate debt. Why? I noticed that a lot of the bigger players in the market, hedge funds had begun offering 30-year fixed rate debt to investors. I think they did this because they realized the same thing you mentioned above. The federal government simply can't afford to have interest rates go too high so they won't.

Also keep in mind if interest rates jump up like they did in the last few months, it is because the economy is trucking along and your rents are likely increasing as well.

Having said that, I'm a big fan of evaluating risks from possible scenarios and planning for those contingencies so here's a few contingency plans I use.

1) As you're already considering, stagger your maturities. You want like 10-20% of the portfolio coming due each year not all of it at once.

2) Also as you're considering, pay stuff down as you can when there isn't something better to invest in.

3) Look into fixing some of the debt for the term of the loan. It sounds like you're existing portfolio may not qualify but there are several companies offering 30-year fixed on 1-4 unit residential.

4) Build up  a cash cushion to see you through any high-interest period. Keep in mind that cash is earning you very little return so balance it closely with number 2 above. I like to save up cash for awhile and then pay off an entire property for instance.

Hi @Greg L.

You already got great advice here. One more thing that I would like to add is to not forget that during the first 7 years of the loan, you are paying down capital and inflation is working for you. 

At the end of year 7, you will have paid down ~18.5% of your initial loan amount (for a 4.75% interest loan amortized over 25 years). There are too many variables to consider, but let's assume that when your loans balloon, the market is stable and the value of your properties have been appreciating at the same rate of inflation. Also, that rents have been increasing at the same rate. 

Couple of options:

a) You want to keep having the same loan amount payment: You can refinance the loan amount due at the end of year 7 with another 25 year amortization loan at a 6.75% interest rate

b) You want to keep the same CF per month that you are netting today: If rates are at 6.75%, you can probably either refinance the amount due at the end of year 7 with a lower amortization period than in point a (your rents are higher) or pull out some equity out at a rate of 6.75%.

c) If rates are lower than 6.75%, you have even more or better options. If they are higher than 6.75%, then your refi loans may be worse than they are today and having saved some capital to pay down loan amounts would help you keep you options open.

Hard to guess what it will happen in 7 years from now (heck, nobody knows what next month looks like!), but planning for different scenarios will help you make the best decisions when the time is due.

Originally posted by @Greg L. :

Thanks all. Maximizing the NOI remains a huge focus, so thanks for emphasizing that again. My credit union is holding these loans on their balance sheet but the longest term I can get is 7 years. There's another local credit union who will give a 10 year lock, but the interest rate is about 100 bp over what I'm paying now. My credit union has done well by me on rates and terms, but have personal and business guarantees from me. I have another business that has accounts with them as well as personal savings.

A 7-year term is not a big deal ... I actually prefer shorter terms as it is easier to pull out equity on the anniversaries ... all of ours are 3-year and 5-year.  If you have a solid payment record, your lender is going to offer to renew on good terms.  You also have the option of shopping your loans around as you near end-of-term.   

I would start staggering  your notes to smooth-out your renewals/refinance. 

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