Do ARM Scare ppl as it we go into a rising rate environment?

Question

Hi all,

Was recently offered a commercial mortgage with the following terms.

Interest Rate: 5.75%

Repayment Schedule: 20 years

Maturity/Term: 5 years

Prepayment penalty: 5,4,3,2,1

Index Value FHLB plus a 2.5% margin.

20% down payment

This doesn't seem terrible however, as we go into a rising rate environment I am a little hesitant on the ARM every 5 years. I've never done a commercial loan before. What are my options if rates keep ticking up and 5 years from now they are to the point where it completely diminishes cash flow? Am I able to refi into another commercial mortgage or would I be left to sell?

Thanks,

Chris Mason · Answer

Residential as well; recast is actually a residential term... the commercial guys might use a different term such as re-amortization.

If you push them enough, many 30YF loans can also be recast if you pay the balance down substantially one-time and get the person behind the 1-800 number of your loan servicer to stop just reading a script and start listening (I'm not going to pretend THAT part will be easy...), think the $20k range in terms of substantial balance paydown. An investor might consider a voluntary re-cast in such a circumstance because it'll lower the P&I and improve cashflow. The reason loan servicers entertain them is because they will overall collect more interest off of you over the life of the loan (without a recast, paying the balance down shortens the loan term, which means less months of collecting ANY interest).

Most common use-case of this is for retail owner occupants who say "I want to buy the next property before selling the old one, but for now I only have 10% down until the old one sells." Great, let's make sure we go with an end-lender that allows for recasting (expect like a $150 to $400 fee to process the paperwork). Sell the old home, take that $200k net proceeds, pay the balance down, recast, enjoy the payment on $200k less of debt (~$1000/mo less). (I know that all the investors just went "WTF NO NO NO, USE THE $200K AS 25% DOWN ON A $800% PROPERTY!!!" :P )

Chris Mason · Answer

It's commercial, so ARMs are the norm.

A characteristic of ARMs that folks often don't talk about is that they re-cast when the rate adjusts. So if you pay the balance down extra, the payment might go down even if the rate goes up. Other than that, yes you can refinance provided there is no prepayment penalty.

Account Closed · Answer

@Michael Doherty all great advice above especially from @Chris Mason and @Mike Dymski.

Honestly the ARM part doesn’t scare me that much. What scares me more is the 5 year term. You say you can just refi or sell, but what if values plummet? What if cap rates double? Many investors lost their commercial properties in 08-09 when the credit markets dried up. Even those at 50% LTV couldn’t find a lender to refi. Some tried selling but with buyers unable to get financing, many people lost their properties.

I’m investing solely in commercial now, and I make it a requirement to get at least a 10 year balloon, or if possible no balloon at all. That way, no one can tell me that I have to refi... or I have to sell.

Steve Vaughan · Answer

Remember, the 5yr rate adjust is also a call if it doesn't outright expire.  Your lender has the right to call it due and payable in full every 5 years. I paid off or refinanced with fixed private money all 3 of mine for this reason (and the hassle of submitting my financials to them every year).

Unfortunately, if they call, they do it when things are tough and others aren't lending on commercial either.  During the GRC none of mine were called thankfully, but no banks had an appetite for new commercial debt. I was trying to expand but couldn't.   Refinancing isn't always an easy task in the commercial space.

Chris Mason · Answer

Push back and try to minimize the prepayment penalty.

Re-casing:

I have a 5/1 ARM on a 20 year amortization schedule at 5%. Original loan balance $500k. P&I is $3299.

I pay a bunch extra, and when it's time for the first interest rate adjustment the balance is down to $350k. Rate adjusts up to 6%. 15 years left. New payment is $2953.

Rate went up and there's only 15 years left, but the payment went down simply because there was less being financed due to me paying it down during that first 5 years.

I might also be sick of the annual audits interrupting my life, another fun characteristic of commercial loans. So perhaps I continue to nuke this debt as fast as possible just so I can own the damn thing free/clear and not have to deal with these audits or rate adjustments.

Michael Doherty · Answer

@Chris Mason can you explain re-cast more? Not quite sure what you mean by this. Again new to commercial lending so trying to absorb as much info as possible. Also there is a pre-payment penalty- 5% 1st year 4% 2nd year ect. Thanks

Account Closed · Answer

Interesting. I am currently refi'ing a 5 unit in Oakland. Local credit union offering 30 year am, no balloon, fixed for 10/10/10, meaning it's fixed for 10, then gets fixed for another 10 years (years 11-20) based on the rate then, and then same thing again for years 21-30. No PPP...by far the best commercial product I've seen, at least in terms of long term comfort.

I originally got the bridge from Lima One in SC (great company by the way)

Mike Dymski · Answer

I have a 7/25 hybrid product...fixed for 7 years, floats for the remaining 18 years...no balloon.

Mike Dymski · Answer

I recommend investing in properties where you can (1) add value and/or (2) have predictable appreciation in value and rents.  In these cases, there will be additional equity and cash flow to absorb potential interest rate increases.

Michael Doherty · Answer

@Chris Mason @Will Gaston  @Richard Sherman @Peter T. all good information, thank you. I'll be honest, some of the info is over my head, but as it relates to the pre payment penalty. If I am a buy and hold investor which I plan to be with this specific property, why does a pre payment penalty really matter? All the bank is doing is ensuring they get their interest for a min of 5 years. I don't see myself having the capital to pay off the note in anything less than 5 years. And even after the 5 years is up and I decide to refi or sell, I will not be penalized.

Do ARM Scare ppl as it we go into a rising rate environment?

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