Property owners sometimes focus almost exclusively on interest rates and set periods 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 the owner’s options at a later date. Before signing on the dotted line, make sure you have answered these nine questions.
1. What are your plans for the property and your goals for refinancing?
Choosing the most profitable financing solution for your apartment or commercial property involves a trade-off between the terms and conditions of alternative loan options. Making a good choice starts with a clear understanding of your or your plans for the property and the purpose for refinancing.
What is the probability that the property will be sold in the future and if so, when? Are you dependent on the income generated from the property now or do you want to maximize the income from the property in the future, perhaps after retirement? Is there any pending maintenance that needs to be addressed now or in the near future?
Are renovations or other major upgrades or improvements expected in the next 5 to 10 years? Do you need to access equity in your property for other investments, for example, to buy another property?
2. What happens after the fixed period?
Some commercial properties or multifamily loans become due and must be repaid at the end of a fixed period and others. These are often called “hybrid” loans and they convert to variable rate loans after a fixed period. Commercial real estate loans or multifamily loans that mature after a fixed period of 5, 7 or 10 years can force refinancing at unfavorable times. Financial markets may be such that refinancing options are expensive or unavailable.
Or local market conditions may result in increased vacancies or decreased rental rates, making your property less attractive to lenders. Often the lowest interest rate agreements are for loans that mature at the end of a fixed period and include more stringent pre-payment penalties (see question #4).
The hybrid loan is converted into an adjustable rate loan at the new interest rate based on the spread of either LIBOR or the main interest rate and is adjusted every 6 months.
3. What is the loan term and amortization period?
The term of the loan refers to when the loan becomes due and must be repaid. The amortization period refers to the period of time during which principal payments are amortized for the purpose of calculating monthly payments. The longer the amortization period, the lower the monthly payment, all other things being equal. For apartment or multifamily properties, amortization is usually available for 30 years.
For commercial properties, 30-year amortization is harder to come by, with many lenders no longer than 25 years. A loan with a 30-year amortization may have lower payments than a loan with a 25-year amortization even though it has a slightly higher interest rate. In most cases the term of the loan is shorter than the amortization period. For example, a loan may be due and payable in ten years, but is amortized over 25 years.
4. If the loan is converted to a variable interest rate after a fixed period, how is the variable interest rate determined?
The variable rate is determined based on the spread or margin above the index rate. The index rate is generally the six-month LIBOR or, less often, the prime rate. The interest rate is calculated by adding the spread to the index rate. The spread varies but is most often between 2.5% and 3.5%.
Rate adjustments most often occur every 6 months until the loan matures. There is generally a limit to how many levels can move at the adjustment point. However, some lenders have no restrictions on the first adjustment. This leaves owners open to large payout increases if rates have moved significantly.
5. What are the prepayment penalties?
Almost all commercial property loans and fixed-rate apartment loans contain some form of prepayment penalty, which means there are additional costs for you if you pay off the loan early, which may occur if you want to refinance or you sell the property or if you want to make payments in excess of the scheduled monthly payments.
The prepayment penalty generally takes the form of a defined prepayment schedule, yield maintenance agreement or, cancellation. A predetermined prepayment schedule dictates a penalty which is expressed as a percentage of the loan balance at the time of payment and decreases with the age of the loan.
For example, the prepayment schedule for a 5-year fixed loan might be quoted as “4,3,2,1” meaning the penalty for repaying the loan is 4% of the balance in year 1, 3% in year 2, etc. . Yield maintenance agreements require a penalty calculated using a formula designed to compensate the lender for lost interest income for the remaining term of the loan above the risk-free rate and discounted to its present value.
The formula can be complex, but the result is almost always a penalty that is more punitive than the established prepayment schedule and will generally make the initial payment financially unfeasible. The third type of punishment, defeasance, is used less frequently.
It works like a yield maintenance agreement in that its purpose is to keep the lender intact for the lost interest income but it accomplishes this by requiring the borrower to replace other securities that will replace the lost income instead of making cash payments. Often the most attractive interest rates offered are tied to loans either by yield maintenance or cancellation agreements.
Generally there is a window of 180 to 90 days before the loan is due when the penalty expires to allow time to arrange for refinancing. These loans generally mature at the end of a fixed period.
6. What are the costs and fees associated with closing a new loan?
Refinancing can be expensive and knowing all the costs is critical to evaluating whether refinancing is the right choice. The largest costs are for appraisals, ownership insurance, escrow fees, environmental reviews, points, and processing and/or loan fees. Assessment fees will be up to $2,000 and up. Phase I Environmental Assessments cost $1,000 or more. Processing and/or loan fees charged by lenders start at around $1,500 and go up from there.
Points may or may not be charged by the lender. Some lenders, particularly for apartment or multifamily loans, will limit spending by $2,500 to $3,000, excluding property rights and escrow. It is important to understand the total cost compared to the monthly savings in debt payments resulting from refinancing. How many months will it take to cover refinancing costs?
7. Can loans be assumed and at what cost?
Many, but not all, commercial real estate loans can be assumed. There is generally a fee, often 1% of the balance, and the assuming party must be approved by the lender. Assumability is especially important for loans with significant pre-payment penalties, such as those with yield maintenance or defeasance clauses, if there is a possibility that you will sell a commercial property or apartment during the life of the loan.
8. Is there a confiscation and if so, what is it?
Some commercial real estate loans and apartment loans will require foreclosure for property taxes or for insurance. A monthly amount is determined and then collected in addition to any principal and interest payments sufficient to cover property taxes and insurance bills as they fall due.
The hold will affect your cash flow from the property because the money for property taxes and/or insurance is collected before they are due. Impounds increase the loan’s effective interest rate because it is an interest-free loan that the owner makes to the lender.
9. Does the lender allow secondary financing?
Finding secondary or second mortgage financing has become very difficult and many lenders do not allow it under the terms of the loan.
However, market conditions may change, making this type of loan more available. If you have a relatively low loan value and it is possible that you may want to access equity in your property to pay for major repairs or renovations, to acquire additional property, or for other purposes, a loan that allows secondary financing can be beneficial.
Securing interest papers from lenders can take time. Many owners simply approach their existing lenders or well-known commercial bank lenders 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’s no way to know without getting lots of quotes. A good commercial loan broker can be very helpful in securing multiple interest papers and help you compare the terms and conditions of each and choose the solution that best suits your goals and plans.