What To Do When Loans Reset At Higher Rates?

The Real Estate Espresso Podcast

What To Do When Loans Reset At Higher Rates?

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What To Do When Loans Reset At Higher Rates?

Welcome to the Real Estate Espresso Podcast, your morning shot of what’s new in the world of real estate investing. I’m your host, Victor Menasce.

The long-awaited pullback in pricing for apartments is here. These properties don’t necessarily need to be poorly performing. The problem lies with properties financed with bank debt from small local regional banks. These smaller banks typically offer loans with a 20-year amortization period, and if the loan was written five years ago, the ten-year treasury yields were fairly low at 0.7 percent. That loan written five years ago would have been priced in the mid-fours. Here’s the crucial part: Most would have been written with a five-year term.

That means, it’s mandatory for that loan to be renewed at current rates, five years from the date of the signature. In many cases, that five-year period has ended. The borrower has the option to renew with the current lender at the current rate with a new loan. But at today’s higher rates, even if the property is performing well, the borrower is likely to be pushed into a corner. The lender is anticipated to reprice the loan somewhere between 6 and 7 percent in today’s market, still with a 20-year amortization. That translates to a much higher loan payment, causing the property to switch from positive cash flow to negative cash flow.

Naturally, the lender is not going to allow the property to operate with negative cash flow, so the loan amount will need to be reduced to bring the loan back into balance. Often, this means a significant cash injection from the borrower. Not many investors want to invest more equity into their existing assets for no other reason than to satisfy a lender.

Some simply don’t have the cash, others lack knowledge to raise it. There are those who are at an age where they’re relying on the property to fund their retirement, and they simply don’t have the time to wait another five years for the property to regain balance. These properties have begun cropping up on the market, selling at a fraction of what they cost only a few years ago. The sellers are cornered and looking for an out.

The situation can be improved by moving out of local bank financing into agency debt with a longer amortization period. Instead of a 20-year loan, opting for a 25 or 30-year loan may reduce the loan payment enough. Even with the higher interest rates, this may still make the numbers more manageable.

Much of the commercial real estate press has focused on the perils of bridge loans converting into permanent financing, but we’re seeing problems in the market for stabilized properties that have already converted to amortized loans.

Some of these shorter amortization loans have a path to maintaining their cash flow by converting to a longer amortization, but the key will be to determine the term of the loan with the longer amortization.

Agency lenders like Fannie Mae and Freddie Mac do offer longer amortization, but they have 5, 7, and 10-year terms. The borrower could face the same dilemma at the end of that term depending on what’s happening in the world of interest rates at that time.

The best financing out there is the HUD-223F loan. In today’s market, this would price below 6 percent with a 35-year amortization. This is one of the longest options available. These loans require a considerable amount of paperwork and are not easy to get. These HUD loans are fully amortized loans where the loan term equals the amortization — you’re not going to be resetting the loan anytime in the next 35 years.

They offer truly permanent financing and if you can make the numbers work at the start of the loan, you should enjoy financial stability for the duration of the loan unless you grossly mismanage the property.

Some of these properties are appearing on the market, selling at a discount in many cases, because the borrower simply lacks the lending relationships that enable them to get better financing. Many borrowers have been dealing with their local bank, possibly for decades, and shifting to a larger national institution seems daunting.

The lender may require additional balance sheet strength that the borrower just doesn’t have, rendering the better financing out of reach.

I’m currently in conversation with the owners of two different portfolios who find themselves in this situation. They’re more inclined to sell the properties at a loss than to consider getting better financing. They recognize that better financing exists in the marketplace, but they are unsure of how to access a more cost-effective loan. The barrier is that some lenders require larger aggregate net worth. In recent years, this requirement has made access to the best financing more difficult to attain.

These loans from Fannie Mae and HUD are non-recourse loans. They’re also consumable, allowing you to sell the loan with the property, assuming of course the buyer qualifies for the loan. There is also uncertainty regarding future policy changes.

Initiatives are underway that would privatize the nation’s largest agencies which have been under a conservatorship by the US government since the 2008 financial crisis. This change, if it happens, may bring about additional policy changes, and we may also see policy changes within HUD.

We’ve already seen changes with Small Business Administration loans. There is no doubt that the combination of higher interest rates and lending policies are affecting the health of the multifamily apartment market. This applies pressure to collaborate with commercial mortgage brokers who are experts in securing the best financing in the business.

As you consider these points, have an awesome rest of your day. Go make some great things happen, and we’ll speak again tomorrow.