***Commercial Loans / ARM****HOW TO PREDICT THE FUTURE?***

33 Replies

Hey Guys!

This question comes from my search in finding the next stage of funding after I max out my 10 conventional 30-year Fannie Mae Mortgages for our rental properties. We've met with several commercial/portfolio lenders and I'm kind of finding the same things everywhere I look. The standard is that either it is an ARM (on a 5 year lock or sometimes 7) - or it has a big balloon payment due at the 5 or 7 year mark as well. I haven't found just a "standard" 20 or 30 year amortized fixed rate loan option, except for ones that are in excess of 9.5% interest rate, which shoots most deals apart in terms of monthly cashflow.

I am wondering for those of you out there dealing in commercial / portfolio financing, how do you evaluate a property for purchase with monthly metrics, when there is an ARM? (ie, how do you predict the future, to know what the rate increase "might be"?)

Or for those of you who do the balloon route, do you just count on refinancing before the balloon payment comes up due? And what if you can't? What then?

Thoughts or suggestions greatly appreciated!

+Seth Mosley

Mosley Properties

Seth, 

We're looking at a similar issue.  A local lender will give me blanket commercial loans on SFRs, but like you its with a 5 year term.

I'd be interested to hear what others have to say. 

Your profile says you're married.  Any chance you can get 10 more loans in her name?

Originally posted by @Frank Jiang :

Your profile says you're married.  Any chance you can get 10 more loans in her name?

 No, she would not financially qualify as I am the main source of income. Good thought though.

@Seth Mosley  you could always consider making her an employee of your operation giving her w-2 income, just a thought. Not a lawyer or accountant so no legal or financial advice. 

I have 9 SFR's and all 9 properties are "commercial loans" with a 5-year call and amortized over 20 years. We just refinance every 5 years (usually sooner to pull our initial investment out and then some if we're lucky). Of course our goal is to be completely out of SFR's and in MFR's in and Commercial property in less than 10 years anyway. Since they are all in my LLC's name, we don't qualify for the typical residential ones. I doubt you'll find a commercial loan for a residential property that doesn't have a 5 or 7 year call. They might be out there, but you'll probably pay for it in points and interest rate.

Originally posted by @Justin B. :

I have 9 SFR's and all 9 properties are "commercial loans" with a 5-year call and amortized over 20 years. We just refinance every 5 years (usually sooner to pull our initial investment out and then some if we're lucky). Of course our goal is to be completely out of SFR's and in MFR's in and Commercial property in less than 10 years anyway. Since they are all in my LLC's name, we don't qualify for the typical residential ones. I doubt you'll find a commercial loan for a residential property that doesn't have a 5 or 7 year call. They might be out there, but you'll probably pay for it in points and interest rate.

 Thanks for writing Justin. So you've never had trouble refinancing at all? No prepayment penalties or issues getting a refi? If refi-ing every 4 or 5 years is all it takes then that doesn't seem to be a bad option at all.

@Seth Mosley  

Here to your north the norm for a mortgage is a 5-year term - either fixed or variable rate - though terms can be as short as 6-mths or long as 10-years.  Yes there is a balloon at the end, but you just simply roll your mortgage over into another as it approaches maturity.

In fact, our preference is for a 5-year, variable rate mortgage with conversion rights {the right to convert into a fixed-rate mortgage of duration equal to, or longer, than the remaining mortgage term. Our biggest frustration when looking at residential properties in the U.S.A. has been the poor selection of variable rate (ARM) offerings.

1(506) 471-4126
Originally posted by @Roy N. :

@Seth Mosley 

Here to your north the norm for a mortgage is a 5-year term - either fixed or variable rate - though terms can be as short as 6-mths or long as 10-years.  Yes there is a balloon at the end, but you just simply roll your mortgage over into another as it approaches maturity.

In fact, our preference is for a 5-year, variable rate mortgage with conversion rights {the right to convert into a fixed-rate mortgage of duration equal to, or longer, than the remaining mortgage term. Our biggest frustration when looking at residential properties in the U.S.A. has been the poor selection of variable rate (ARM) offerings.

 So Roy, you've never hit a wall with rolling your mortgage into another as it approaches the balloon? (refinancing)

Glad to hear this is a viable option if so..

@Seth Mosley  

We've never had a problem, but we are dealing with a different banking system up here ;-)

In the U.S.A. we presently have a commercial variable rate (ARM) mortgages, which have not yet to come to maturity.

1(506) 471-4126

Thanks for the reply!

@Seth Mosley

Different ways to do this, based on loans we're currently doing. Can take those 10 properties and lump into 1 commercial loan and then continue to get more Fannie Mae loans. Rates will likely be higher than what you're currently paying but it will save you headache. 30 year am, can go up to 10 year term. Could even likely do a 30 year fixed, but rates likely be in the 6s-7s. OR...you can continue to purchase 1-4 units with lenders we also know of that will do a 30 year fixed rate commercial loan, up to 75 LTV, rates usually in the 7s. Min loan amount of $75k. Lender will only do up to 10 loans per borrower but doesn't care how many properties overall a borrower has.

Hope that helps.

Thanks,

Jared Rine, Lender in California (#893462) and California (#01915324)
(209) 481-0514

As a SFR investor and a commercial lender myself (since 1999), I think I can speak on the topic. A commercial loan is not a residential mortgage loan and can be alot more forgiving in the approval and documentation process. Also, there's usually just an origination fee (1.0% of the loan amount) and no underwriting, doc prep, credit report, rate lock, or whatever other fees they tack on residential mortgage loans. One last thought, there is no maximum number of commercial loans you can have (either in your name or an LLC) and a single commercial loan can include multiple properties.

That said, commercial loans do have limited terms and conditions vs a residential mortgage. The max term is generally 5 years (fixed or variable rate) with a 15 or 20 year amortization depending on the dollar amount and condition of the property. 5 year fixed rates (in NC) are in the 5-6% range right now and a variable rate is probably Prime+1-2% (4.25-5.25%). With the variable rate, a floor/mimimum rate is usually established that kicks in with our current rate environment. The floor rate is generally 0.5-1.0% over the current variable rate realizing that variable rates (Prime) will increase in the coming years. That said, I try to point out that variable rates will most likely go up over the next 5 years and the fixed rate may be the safer bet and allow you to sleep a little better at night.

Regarding the balloon 5 years out, as long as the loan has been paid as agreed and the bank is still in business, the bank will generally want to keep the loan on the books and offer competitive renewal terms. The process at maturity is the same at origination. Provide updated financials, get an updated appraisal, and sign a short renewal/modification agreement (there's usually a nominal renewal fee as well). Signed, sealed, and delivered with no attorney closing stuff and the loan is set for another 5 years. When I'm at the closing table (at loan origination) I generally say that in 5 years we'll get updated financials/appraisals, and update the rate and payment accordingly.

Hope this helps and I welcome any and all feedback.

Originally posted by @Seth Mosley :
Originally posted by @Justin B.:

I have 9 SFR's and all 9 properties are "commercial loans" with a 5-year call and amortized over 20 years. We just refinance every 5 years (usually sooner to pull our initial investment out and then some if we're lucky). Of course our goal is to be completely out of SFR's and in MFR's in and Commercial property in less than 10 years anyway. Since they are all in my LLC's name, we don't qualify for the typical residential ones. I doubt you'll find a commercial loan for a residential property that doesn't have a 5 or 7 year call. They might be out there, but you'll probably pay for it in points and interest rate.

 Thanks for writing Justin. So you've never had trouble refinancing at all? No prepayment penalties or issues getting a refi? If refi-ing every 4 or 5 years is all it takes then that doesn't seem to be a bad option at all.

Our first property was in 2010 and our second in 2012.  Our first one would be coming up in August of this year but we re-financed it last year.  We realized we had enough equity to refi and pull out every $ we had put in (plus a couple of K) before the 5-year mark.  For our remaining properties, we're already looking at refinancing the one we bought in 2012 this year (and pulling out at least our down payment) and our next group isn't due until 2018.  So we technically haven't hit the 5-year mark yet.  However because we've already re-financed one, it's the same thing.  We had no pre-payment penalties.  Almost no bank will hit you with a penalty at the end of your arm.  They fully expect you to refi it again at the end of your arm at whatever the market interest rates are at the time.  In fact, our refi was simple.  The bank didn't even require a new appraisal, they just did an in house eval and used that #.  It only cost us like $300 to refi and the bank even rolled that into the loan too.  So we refi'd, pulled our original down payment + $2k out in cash, and are back on the 5-year clock.  Fortunately the interest rates didn't changed much and our new loan is .25% below our original.

For the short direct answer.  No, there shouldn't be a pre-payment penalty (if there is, run from that bank).  Yes, they fully expect you to refi at the 5-year mark or even before.  Yes, it's easy to just keep doing it until you no longer own that property.

We pulled out money and kept the payment the same, but you don't have to pull out money and your payment will go down. The banks love arms now because let's face it, interest rates aren't going down. They are banking on the interest rates going up and they know they most likely get to raise them if that's the case in 5 years instead of waiting 20. After 5 years, the amount you owe on the morgage is less and the rent you are charging should have gone up several times so it really shouldn't be an issue even with an interest hike at the end of the ARM. Worst case even with a big interest hike, with rent raises and mortgage paydown over those 5 years, your cash flow would pretty much be the same.

Interests rates will go up that's for sure. I always favored the fixed rate and sleep better at night. You can get 4.5-5% 5,10 and some times 15 year term with 20-30 year amortization but this is depending on the relation that you have with the financial institutions that you deal with which everyone has different financial situation and experience .

Originally posted by @Ned Carey :

First of all interest rates are going up - Period. We just don't know when or how fast.  This is a major risk that most commercial buyers seem clueless to. 

 Ned,

I'm not sure I entirely agree about the clueless commercial buyers, but perhaps I make too large an assumption on how other folks underwrite.

Interest fluctuation is a routine fact of borrowing here in Canada, and most other places in the world, where mortgage terms - both residential and commercial - are definitively short in comparison to the U.S.A. (6-months to 10-years here in Canada with 5-year being the "norm").  In fact, the concept of a long-term fixed rate mortgage is a U.S.A. only phenomenon {to the best of my knowledge}.

When analysing an acquisition or reviewing the operational budget of an existing property, you always do so with the assumption that interest rates will be higher at the end of the present mortgage term.  In fact, because we tend to use variable rate mortgages we do our analysis as if rates were higher from the point of purchase and often set our debt service payments in accordance with the higher rate (or at some reasoned point between our "worst case" analysis and present rates).   

As an example, this morning I am analysing a 36-unit property where, if acquired at our intended offer, the amount financed would be 1.6-million.   In my analysis I have used an interest rate of 4.25% (30yr amortization, 5-yr term) which results in by-weekly payments of $3936.   After meeting with my lenders last week, I know the rate at which we can presently borrow is 2.7% (30yr amortization, 5-yr term, variable rate), which results in payments of 3245 bi-weekly.   Assuming this deal Closes and we stick with the worst-case model, we will make bi-weekly debt service payments of $3936, despite the note being at 2.7%,   The delta, $691/payment ($17,966 /year), will go directly to principal reduction.  When interest rates climb later this year (0.25 - 0.75 is being forecast by the BoC), our payment will not change, but our amount of principal pre-payment will diminish.

If our assumptions are incorrect, the central bank reverses its guidance {as has happened for the past three years}, and rates hold steady (as they have been) over the entire 5-year term we will have reduced our debt by an additional $96,119; reduced the effective amortization to 20.35 years and reduced our carrying costs (interest paid) over the full amortization by $255K.

If interest rates climb the 3/4 of a point indicated by the central bank (to 3.45%), we will see no impact to our operations (we planned for 4.25%).  We will continue to make debt service payments of $3936, but only 366/payment ($9516/year) will go towards principal pre-payment.

Now, in reality we would likely only make debt service payments as if the interest rate were 3.45% ($366 extra) not 4.25% ($691 extra) and put the difference ($325) into reserves.

1(506) 471-4126
Originally posted by @Roy N. :
Originally posted by @Ned Carey:

First of all interest rates are going up - Period. We just don't know when or how fast.  This is a major risk that most commercial buyers seem clueless to.

When analysing an acquisition or reviewing the operational budget of an existing property, you always do so with the assumption that interest rates will be higher at the end of the present mortgage term.

Roy, based on the cap rate compression we have here I don't think many commercial buyers are thinking that way.

I'm not sure I entirely agree about the clueless commercial buyers

It is hard to believe I am the only one to figure this out. You obviously understand what I am about to say. 

If cap rates de-compress and return to historical norms, values will drop. This is likely to happen as interest rate return to long term norms. NOI will have to increase significantly just to maintain value. If interest rates are higher when your loan comes due, then your net cash flow drops also. Gee lower values and lower cash flow seem like a big risk to me. That is why I said "Clueless"

Assuming this deal Closes and we stick with the worst-case model, we will make bi-weekly debt service payments of $3936, despite the note being at 2.7%, 

This is fascinating. Is this how you personally mitigate your risk or is this actually a requirement of lenders to handle it this way?   This seems like a brilliant way to soften market cycles and reduce risk at both teh individual and the overall market level.

Welcome to the world of non real estate business loans. The rates, terms and amortization period that you are being quoted is very common for the commercial real estate loans that businesses get. Equipment loans are worse.

I always wondered growing up how a business could make long term decisions knowing that the deal would be renegotiated in 7 or ten years at prevailing interest rates, but the short answer is because they have to.

I just met with our banker last week and was told the same as what you are seeing. A five year credit line at 1/4% under prime and a ten year fixed commercial loan with a twenty year amortization.

Moving to the commercial loan sphere for SFH just adds another layer of complexity to your analysis, what happens if the environment is terrible in ten years when you have to refinance the debt. . .

Originally posted by @Ned Carey :
Assuming this deal Closes and we stick with the worst-case model, we will make bi-weekly debt service payments of $3936, despite the note being at 2.7%, 

This is fascinating. Is this how you personally mitigate your risk or is this actually a requirement of lenders to handle it this way?   This seems like a brilliant way to soften market cycles and reduce risk at both teh individual and the overall market level.

Ned:

This is our approach to mitigating interest rate risk, while leveraging the lowest effective rate we can obtain.  It is neither brilliant, nor likely unique and is actually a hold-over from how I paid the mortgage on my personal residence many years ago.    

Here in Canada, mortgage interest on your primary residence is not deductible against your income at tax time.  Since all interest payments on your mortgage come from after tax dollars, there is real motivation to minimize the amount of interest paid {which is part of the reason the default rate on residential mortgages in Canada is <1%... often <0.75%).  One of the easiest methods, which need not require additional cash, it to make bi-weekly mortgage payments - this alone can shave 5-years of a 25-year amortization and save thousands in interest charges.  

The second easy tool is to take a variable rate note, as opposed to fixed rate, when placing your mortgage.   The interest rate on a 5-year term, variable rate mortgage is typically 0.6 to 1.2 points lower than that of a 5-year term, fixed rate mortgage (the most popular residential mortgage in the country).   Furthermore, to qualify for a residential mortgage, a person must qualify for a 25-yr amortization at the BoC 5-year term fixed rate {which is typically prime + 0.5 ... higher than what a good credit history will net you with a class A lender}.   

If you remember the 1980s, then you know what *real* interest rates can look like.   When we bought our first primary residence I qualified at a 5-year fixed rate at 12-14% (I cannot remember precisely), but the rate 5-year term variable rate mortgage was over 1% less ... and the product was convertible into a fixed rate mortgage (of equal or longer duration than the balance of my term) at any time ... so if, I got cold feet, there was an easy, albeit expensive, way to piece of mind.   We took the variable rate mortgage, but set our payment to be that required to service a 5-year term fixed rate mortgage; made bi-weekly payments and paid off a 25-year mortgage in just over 12 years (after rolling my wife's student loans onto the balance during our second renewal ... without that we would have been mortgage free in ~10 years).  We saved over 65K in interest versus if we had gone with the fixed-term mortgage and minimum monthly payments.

I've carried over basically the same approach to my real estate investment.  Though the motivation to minimize interest costs is not as great (given they are deductible against income for an investment), we still go with a variable rate mortgage (or LoC), but insulate ourselves against interest rate shock by structuring our operations around the debt service requirements of a 5-year fixed-rate mortgage.  As indicated above, we do not always make the full worse-case level of mortgage payment - sometimes there is better use for the cash - but we make certain we can make that payment if or when the need arises (i.e. rates shoot up).

Essentially, we make the same mortgage payments as the majority of Canadians who opt for a 5-year fixed-rate mortgage (something like 3/4 of the market), but we pay down more of or debt as we manage our own interest rate risk rather than paying the bank a higher interest rate to manage it on our behalf.

BTW:  I concur on the cap-rate compression.  I would like to see something instigate a correction in Canadian real estate markets and pull prices back towards their historic ratio relationship to income and rents.

1(506) 471-4126
Originally posted by @Roy N. :

If you remember the 1980s, then you know what *real* interest rates can look like.  

Yes my first loan was 12%. Wow was I excited to get something that low. I laugh at new investors that think a 5% rate is high. They don't realize 6 or 7% is dirt cheap. 3% for home loans is as good as free.

This is our approach to mitigating interest rate risk,   .   .   .   It is neither brilliant, nor likely unique

Well I think it is both. Maybe you Canadians are just a lot smarter than us.

I have a lender that will do 30 year amort, with a 15 year ballon. It's fixed for the first 5 years and no prepays. I can refer you if you would like.

Originally posted by @Michael McGovern :

I have a lender that will do 30 year amort, with a 15 year ballon. It's fixed for the first 5 years and no prepays. I can refer you if you would like.

 Please do refer! :)

I will email you her contact info.

Originally posted by @Michael McGovern :

I have a lender that will do 30 year amort, with a 15 year ballon. It's fixed for the first 5 years and no prepays. I can refer you if you would like.

Please Refer.  Thanks

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