Property owners sometimes focus almost exclusively on the interest rate and the period for which it is fixed when choosing a new commercial real estate loan or multifamily loan. However, other factors have a significant impact on the “total cost of capital” and can limit or expand owner options later on. Before signing on the dotted line, be sure you have answered these nine questions.
1. What are your plans for the property and your objectives in refinancing?
Choosing the most advantageous financing solution for your apartment or commercial property involves weighing tradeoffs between the terms and conditions of alternative loan options. Making sound choices begins with a clear understanding or your plans for the property and objectives in refinancing. Is it likely that the property will be sold in the future and if so when? Are you reliant on income generated from the property now or are you looking to maximize income from the property in the future, perhaps after retirement? Is there deferred maintenance that needs to be addressed now or in the near future? Is remodeling or other major upgrades or repairs expected in the next 5 to 10 years? Will you need to access the equity in your property for other investments, for example, to purchase another property?
2. What happens after the fixed period?
Some commercial property or multifamily loans become due and payable at the end of the fixed period and others. These are often called “hybrid” loans and they convert to variable rate loans after the fixed period. A commercial real estate loan or multifamily loan that becomes due after the 5, 7 or 10 year fixed period may force refinancing at an unfavorable time. Financial markets may be such that refinancing options are expensive or unavailable. Or local market conditions may have resulted in increased vacancies or reduced rents, making your property less attractive to lenders. Frequently the lowest interest rate deals are for loans that become due at the end of the fixed period and include more restrictive pre-payment penalties (see question #4). Hybrid loans convert to an adjustable rate loan with the new rate being based on a spread over either LIBOR or the prime rate and adjusting every 6 months.
3. What is the term of the loan and the amortization period?
The term of the loan refers to when the loan becomes due and payable. The amortization period refers to the period of time over which the principal payments are amortized for the purpose of computing the monthly payment. The longer the amortization period the lower the monthly payment will be, all other things being equal. For apartment or multifamily properties, 30 year amortizations are generally available. For commercial properties, 30 year amortizations are more difficult to come by, with many lenders going no longer than 25 years. A loan with a 30 year amortization may have a lower payment than a loan with a 25 year amortization even if it carries a slightly higher interest rate. In most cases the term of the loan is shorter than the amortization period. For example, the loan may be due and payable in ten years, but amortized over 25 years.
4. If loan converts to a variable rate after the fixed period, how is the variable rate determined?
The variable rate is determined based upon a spread or margin over an index rate. The index rate is generally the six-month LIBOR or, less often, the prime rate. The interest rate is computed by adding the spread to the index rate. The spread varies but is most often between 2.5% and 3.5%. The rate adjustment most often occurs every 6 months until the loan becomes due. There is generally a cap on how much the rate can move at an adjustment point. However, some lenders have no cap on the first adjustment. This leaves the owner open to a large payment increase if rates have moved significantly.
5. What are the prepayment penalties?
Almost all fixed rate commercial property loans and apartment loans contain some form of pre-payment penalty, meaning there is an additional cost to you if you pay off the loan early, which may occur if you want to refinance or you are selling the property or if you want to make payments greater than the scheduled monthly payments. Prepayment penalties generally take the form of a set prepayment schedule, a yield maintenance agreement or, defeasance. A set prepayment schedule predetermines the penalty expressed as a percentage of the loan balance at payoff and declines as the loan ages. For example, the prepayment schedule for a 5 year fixed loan might be quoted as “4,3,2,1” meaning the penalty to pay off the loan is 4% of the balance in year 1, 3% in year 2, etc. A yield maintenance agreement requires a penalty computed using a formula designed to compensate the lender for the lost interest revenue for the remaining term of the loan over a risk-free rate and discounted to a present value. The formula can be complex, but the result is almost always a more punitive penalty than a set prepayment schedule and will generally make early pay-off financially unviable. The third type of penalty, defeasance, is used less often. It works like a yield maintenance agreement in that its intent is to keep the lender whole for the lost interest revenue but it accomplishes that by requiring the borrower to substitute other securities that would replace the lost revenue instead of making cash payment. Often the most attractive interest rates offered are associated with loans with either a yield maintenance agreement or defeasance. There is generally a window starting 180 to 90 days before the loan is due when the penalty expires to allow time to arrange refinancing. These loans generally become due at the end of the fixed period.
6. What are all the fees and charges associated with closing the new loan?
Refinancing can be costly and knowing all the costs is essential to evaluating if refinancing is the right choice. The biggest costs are for appraisals, title insurance, escrow fees, environmental review, points, and processing and/or loan fees. Appraisal fees will run $2,000 and up. Phase I Environmental Assessment cost $1,000 and up. Processing and/or loan fees charged by the lender begin about $1,500 and rise from there. Points may or may not be charged by the lender. Some lenders, particularly on apartment or multifamily loans, will cap the expenses at $2,500 to $3,000, excluding title and escrow. It is important understand the total costs in comparison to the monthly savings in debt service resulting from refinancing. How many months will it take to recoup the costs of refinancing?
7. Is the loan assumable and at what cost?
Many, but not all, commercial real estate loans are assumable. There is generally a fee, often 1% of the balance, and the assuming party must be approved by the lender. Assumability is critical for loans with significant pre-payment penalties, like those with yield maintenance or defeasance clauses, if there is some chance you will sell the commercial or apartment property during the life of the loan.
8. Are there impounds and if so what are they?
Some commercial real estate loans and apartment loans will require impounds for property taxes or for insurance. A monthly amount is determined and then collected in addition to each principal and interest payment sufficient to cover the property tax and insurance bills as they come due. Such impounds will affect your cash flow from the property because monies for property taxes and/or insurance are collected in advance of when they are actually due. Impounds increase the effective interest rate on the loan because they amount to an interest free loan the owner is making to the lender.
9. Does the lender allow secondary financing?
Finding secondary or second lien financing has become quite difficult and many lenders do not allow it under the terms of the loan. However, market conditions may change, making this type of lending more available. If you have a relatively low loan to value and there is a chance you might want to access the equity in your property to pay for major repairs or remodeling, to acquire additional properties, or for other purposes, a loan that allows secondary financing can be beneficial.
Securing a letter of interest from a lender can be time consuming. Many owners approach only their existing lender or a well-known commercial bank lender in their area and assume that the offer they get is the best available. This is not always the case. In many cases, smaller or lesser known lenders offer the most aggressive or flexible terms. There is no way of knowing without getting multiple quotes. A good commercial loan broker can be very beneficial in securing for you multiple letters of interest and helping you compare the terms and conditions of each and select the solution that best meets your goals and plans.