Posts Tagged 'Fannie Mae DUS'

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Fannie Loosens the Reigns

You know the recovery may actually be happening when lenders start getting more aggressive.  I wouldn’t say the recent Fannie changes are aggressive, but they so represent a crack in the underwriting wall that was built in the end of 2008.

Many of the changes are technical and relate to how they look at trailing income and underwrite properties that are collecting less today than they were a year ago.   They also made changes to their underwriting rates for 7 year loans.   Fannie uses an artificial underwriting rate to evaluate loans and for what they consider short term loans (5 and 7 years) this rate has been well above current rates.  This has had the effect of reducing the loan amount available on most loans, especially high quality loans in low cap rate markets.    The change in underwriting rates in not dramatic, but will help the 7 year borrower achieve a slightly higher loan amount.

The most notable changes Fannie made to their multifamily programs was to reduce the number of loans they have to pre-approve from the DUS lenders.   For most of the last 18 months many markets were pre-approval markets with any deal in the market having to be reviewed by Fannie.  Fannie has just allowed loans under 65% LTV (Tier 3 and 4 loans) in almost all markets to be made without pre-approval.  This will speed up the process on these loans and make the experience better for borrowers.  Of course if you are looking for maximum leverage in these markets you will still need pre-approval and the delay in the process that causes.

In addition to these changes Fannie is just more aggressive at looking at waivers to their rules.  They have approved 10 year I/O deals even on fully leveraged transactions.  The one area where I would say they are not being flexible is on the borrower.  They want strong borrowers with good liquidity and no global real estate issues.   On small loans they will not generally make FICO waivers and liquidity is king.  If you don’t have any don’t expect to get a loan.

Notes from CREF – Commercial Real Estate Finance Confrence

This week commercial lenders and brokers got together in Las Vegas to discuss the state of the commercial real estate business and to convince each other to do business.   The meeting was well attended and optimism was in the air.  Everyone thought business would be good this year, well at least in comparison to last year.   But how could it have been worse given in 2009 lending was way down and real estate values collapsed.   While this meeting was focused on all types of commercial real estate, but a large part of the focus was on apartment lending. 

There were not many new announcements from Freddie or Fannie.  Both lenders stressed that they will continue to support the market and that they do not expect government action to change their structure  or focus during 2010. 

HUD was one of the big topics of the conference.  Over the last year this has been a main lender for many brokers/mortgage bankers.  For years HUD has been seen as a process oriented lender and one that does not really look at risk in the same way as the rest of the market.  It looks like that might change.    As mentioned in previous postings, HUD is planning on changing their underwriting criteria.   Based on comments made at the MBA it also seems that they will change their focus to a more market oriented approach.  Only time will tell.

Life Companies and  Conduits were abuzz about lending again.  Most Life companies were back in th market and a bunch of conduits were also back, at least for larger deals.   However, these lenders all indicated that they would not compete with Freddie and Fannie on apartment rates and therefore were focusing on other areas of commercial real estate.  It’s good that these lenders are back, but for now that won’t really effect the multifamily lending market.

There were no big announcements or sunrises at the meeting, but based on the tone and vibe at the event most professionals think commercial real estate lending may be ready to emerge from its cocoon.   I am not as optimistic and think we have another year or so before we start to see significant lending activity.    However, you have to walk before you run and I think we will be at least walking  (or crawling) this year.

Fannie Mae Small Multifamily Loans – Demystified

During the economic crisis of the last two years many banks that traditionally made loans to owners of small apartment properties have either left the business or cut back on lending.  This has left many owners of small apartment properties with limited borrowing choices.  One lender that has stuck with the small multifamily market and even expanded their outreach is Fannie Mae.  A number of Fannie Mae DUS lenders have embraced this program and its being marketed by almost every loan broker/banker in the country.   This program is different from bank loans that most owners are familiar with and many of the brokers/bankers who are selling the program don’t really know how it works.    Hopefully this article will explain some of the issues with these loans and make it easier for you to evaluate these loans.

First lets talk about who makes these loans.   These loans are made by one of a few select small loan lenders and then are either sold to Fannie Mae or are sold as Fannie Mae guaranteed mortgage-backed securities.  Because Fannie either buys the loans or guarantees the bonds backing the loans they must follow Fannie Mae guidelines.   According to the Fannie Mae web site there are 12 Market Rate Small Loan Lenders.  However, not all of these lend in every market and many are really not active in lending today.  My experience shows that there are really 4-5 lenders who are actively pursuing this business.  These lenders predominantly work through mortgage bankers/brokers and do not work directly with borrowers.

Let’s take a brief look at the program.  The basic program terms (listed below) are very similar to the standard Fannie Mae DUS program.  These are long-term fixed rate balloon mortgages with excellent rates, but a harsh prepayment premium. 

Loan Amount:

$500,000 – $3,000,000 ($5,000,000 in major markets)
Loan Term: 5, 7 or 10 year terms
Amortization: Typically 30 years, but shorter amortization schedules are available
Loan to Value Ratios: Up to 80% LTV, but 75% is more typical
Debt Coverage Ratios:  Over 1.25x
Pricing/Rates: Risk based pricing based on the properties LTV and DSCR – Rates are fixed for loan term, adjustable rates are available
Personal Recourse:  Non-recourse is available, but recourse is sometimes required
Prepayment Premium:

Typically Yield Maintainance

While these are the basic terms, it must be understood that these terms are not offered on every deal or in every market.   Most lenders are only interested in making these loans in major metro markets.   Loans are available in smaller markets, but typically on more conservative terms and not with every lender.  Also, while Fannie Mae has guidelines some lenders are more conservative than Fannie and won’t make certain loans even if they fit the guidelines.  Others stick to the letter of the law and won’t ask Fannie for a waiver of the guidelines when it might be warranted. 

The Process – The first thing to understand is that these loans have a process and they require a bunch of documentation.   These lenders do not issue a commitment or lock rate until all the reports are in and all the underwriting is complete.   However, once the commitment is issued rate lock and closing can be done quickly.    As a general overview of the process the lender will review some basic information about the properties historical income and the borrower’s financial situation and then issue a quote or application.  This application will not guarantee the borrower anything, but is an indication of what the lender believes they can do.  If the borrower likes the quote they will sign the application and provide the lender with an application deposit.   The lender will request a number of other documents from the borrower and will order the appraisal and other reports.  Once the reports are in and the borrower has submitted all the required documentation they will complete their underwriting and issue a commitment.    Total time from application to commitment is typically 30-60 days.  After the commitment is accepted and the borrower posts a good faith/rate lock deposit (1%-2% of the loan amount) the lender will lock the rate and quickly close the loan.

The biggest issue in the process is the amount of paperwork that the lender will request.  They will ask for organizational documents, personal financial statements, copies of bank statements, real estate schedules, property income and expense statements, copies of leases as well a numerous forms.  These are required and there really are no shortcuts.  You need to give them this information when they ask for it in order to get your loan.    The process will go smoother with a mortgage broker/banker who has experience with this program and if you have a good attorney who is brought on board at the beginning.  However there is no way to eliminate the paperwork or process.  Just go with the flow and know that in the end you will get a good loan.

Rates – The rate is determined by a number of factors including the LTV and DSCR (based on the actual rate or an underwriting rate) on the property as well as the loan size and term.  Because of this you may get different quotes from different lenders depending on how aggressive they are in both their preliminary (quoting) underwriting and in their final underwriting.  Some lenders will be much more aggressive on their preliminary underwriting in order to get a borrower to sign an application, but may not deliver that quote at commitment.  The rate may also consist of pricing add ons for different features or fees to the lender or broker.   It is hard to determine what add ons have been charged and if the lender or broker is taking a premium.  If you ask your broker/banker about the rate build up, they should be able to give you an idea of the rate build up. 

Since the rate on these loans is not locked until after commitment the rate can change.  When getting a quote a lender will give you the current rate as well as a spread on the loan.  While the spread is not locked it should not change much during the process.  Having the spread allows you to track the rate.   If, when you get the commitment, the spread is different than on the quote you should ask about this to understand the differences and what occurred.

Costs – The transaction costs on these loans vary by market and lender.  The processing of these loans costs lender almost as much as on a larger Fannie Mae loan.    The lender must pay for their staff, an appraisal, physical needs and environmental reports and lender legal.    These costs often run well over $10,000 per loan.   Some lenders are taking a deposit at application and charging actual costs of the appraisal, engineering report, and lender legal to the borrower.  However, most are capping their fee at the amount of the application deposit and paying for any additional costs by increasing the rate.   Today most lenders are charging a deposit $4,500 in major markets and up to $10,000 in smaller markets. 

In addition to the transaction costs on these loans you will have to pay for title, possibly a current survey and your own legal.   These costs vary by market and property.  The other cost of the transaction is the origination fee.   The lender themselves will charge some fee, but this is often built into the rate and is not identifiable.  However, the mortgage broker or banker showing you this loan needs to make a fee.  This can be paid as a direct fee or as additional rate into the loan.    Depending on the loan term, amount of fee being added and LTV the add-on can increase your rate by ½% or more.   I encourage you to ask the broker/banker if they are getting paid by the lender and if so how much the rate has been increased for their origination fee.  Typically brokers will make 1% of the loan amount (1 ½% for some smaller loans).  If you are getting charged more than that you should check around or give me a call.  Mortgage brokers/bankers should get paid for their work because they do provide you value, but that does not mean they should overcharge you for their services.

Underwriting – The underwriting of these loans is also a bit different than most small multifamily owners are used to.    The income and expense analysis is straightforward.  The lender looks at the current rent roll, adds in miscellaneous income and applies a vacancy rate to get their underwritten effective gross income (EGI).    Today lenders will be very careful to compare the EGI to historical collections and may ask for a trailing 12 month statement to show collections for the last 3, 6, 9 or 12 months.   If the trend is not favorable then the lender may underwrite a more conservative vacancy figure.  Expenses are underwritten based on the last full year’s expenses and what the appraiser says are stabilized expenses for the property.  Additionally a replacement reserve figure is underwritten based on the engineer’s estimate of replacement over the life of the loan.  This is typically $250-$300 per unit per year, but can be higher on older properties and is often the number most understated at preliminary underwriting.

The borrower and borrowing principals are also carefully underwritten by the lender.  They are looking for borrowers with FICO scores over 680 (over 720 is better) and who have strong financial strength.  Typically they want to see borrowers with a net worth greater than the loan amount and liquidity greater than one year of loan payments (principal and interest).   Lenders will verify liquidity by requesting bank statements and will only consider liquidity they verify as legitimate.  The other borrower item underwritten is their global real estate schedule.  The lender will require an extensive real estate schedule listing all properties, their current loans and current income and expense.  They will analyze the borrowers’ global cash flow and make sure there are no properties with either risky ballooning mortgages or significant negative cash flow.

One additional item to consider in underwriting is the engineering report/analysis.  Each lender has someone look at the physical condition of the property.  This may be an engineer or just a property inspector.  This person will determine what items at the property are not in good condition and need to be repaired or replaced.  They will also estimate the costs of capital improvements over the term of the loan and thus the replacement reserve used in underwriting.   This is probably the biggest difference between this type of loan and a typical bank loan.  Be prepared, the lender may make you repair/replace some items before closing or within a few months of closing.   This does not mean you are running a bad property; it’s just that they are looking at this as a loan for a long term and want to make sure there are no life-safety issues that could cause a problem and that the property is maintained in good condition.  One way to avoid this issue is to make sure the property is in its best condition before an inspection and to know about the property so any questions that occur are answered quickly and thoroughly.

Why this loan – With all these requirements why should I even consider this loan.  Well the main reason is a long-term loan at very low fixed rates.   Most of these loans are for 10 years with the rate fixed for the term of the loan.  There are not many lenders willing to offer long-term loans on smaller properties.  Also, the rates are very attractive.  For most of 2009 the rates being offered on these 10 year loans were a good 1/4% lower than rates on 3 or 5 year loans being offered by banks.  And for shorter term loans such as a 5 year loan the rates are often ¾%- 1% lower than bank offerings.   Additionally, today many banks are only lending up to 65% LTV while these loans are typically 75% LTV, sometimes up to 80%.

The second reason is these are often non-recourse loans.  Banks are almost always recourse lenders.  This means if the deal fails and you default on the loan they can go after your personal assets to pay the loan (this varies based on local law).  On a non recourse loan they can only take the property leaving all your other assets protected.  This is especially important for someone with investors and therefore does not own the whole property. 

From my perspective the biggest negative of these loans is the prepayment premium.  These loans almost always carry a yield maintenance prepayment premium.   I won’t explain how that works here, but let’s just say it means you should not expect to pay off the loan until shortly before it matures.   You can pay it off, but the premium (penalty) may be very high.  Smaller owners are used to a step-down prepayment premium.   This way you know the amount of the prepayment premium and you have some flexibility if you want to sell.   Such flexibility is nice, but it comes at a cost.  If you want a long-term loan and this type of rate this is the cost of obtaining it.  These lenders can offer you a step-down, but the rate is much higher.   The loan still allows you to sell the property and have the new owner assume this loan, so you are not totally stuck, but your flexibility is limited.

 Things to watch

  • Understand the quote before you decide to take the loan.  Talk with your broker and make sure you are considering all the issues when comparing this to another quote.  One item to evaluate is that these loans are quoted with an actual/360 calculation so the rate is not fully comparable to a 30/360 quote from a bank (see 30/360 vs. Actual/360).  Another issue is many of these lenders quote the loan on just the DSCR.  They don’t cut the loan quote based on value, but state the maximum LTV for the loan.  Make sure you are comfortable the value that is needed before you start the process.
  • Know the costs of the deal.  If you have to give a deposit of more than $4,500 in a major market or $10,000 in a smaller market you should know why.  Also, make sure the costs are capped or spelled out.  Finally, manage your own costs.  While I believe you need an attorney to close one of these loans, they should understand that the documents are not negotiable so don’t waste time, and money, trying to negotiate them.
  • Understand the rates/spread.  There are lots of premiums being included in these loans to pay for the transaction costs and to make sure the lender is adequately compensated for their work.  However, this leaves opportunity for lenders and brokers to overcharge you for your loans. 
  •  Know the lender you are dealing with.  All of the lenders participating in this program are not the same and each treats things differently.   Some will push for and can get waivers from Fannie and some wont.   I suggest you work with a broker/banker who has experience working with more than one of these lenders so they can advise you as to which lender is best for your individual situation and property.

This article tries to explain the main issues and with this program, but there are lots of features and issues that I did not address.  If you have more detailed questions on this program or want to discuss any specific deal please shoot me an e-mail at aklingher@mfloan.com or give me a call at 847-421-2217.

MFLoan Rate Update – November 2009

Well we bounced off the high of the 10 year treasury at 3.50% and headed downward for the month.  The treasury is down   .   This is trader speak sums up what has been happening all summer and what has been controlling rates for most multifamily borrowers.    Since March the 10- year treasury has fluctuated between 3% and 3.5%.  For us working on financing properties we are in constant worry that treasuries will break out of this range and interest rates will increase dramatically.

As the month ended we were near the top of that range, but on Friday it reversed as the stock market started to correct (Crash?) and the dollar started to strengthen.  The question on everyone’s mind is what the Fed will do next week and if their statement will make the market think rates will be on the rise.  I don’t think the Fed will make any changes and the 10-year treasury will continue in this range for the rest of the year.   Next year is another story.  If that happens we will have another month where multifamily rates stay steady. This is a good thing.  The stability of multifamily rates has been the only bright spot in the market. 

Despite many anecdotal comments that the sales market is opening up there is little actual evidence that sellers are setting more realistic prices or buyers are looking for market deals and not just steals.  The press has increased its talk of a further commercial real estate melt down which increases anxiety for buyers, sellers and borrowers.  Banks are still extending bad loans rather than taking the pain now.  This is probably a good thing for each bank, but not necessarily good for the system.  No matter who it is good for it will make the pain last longer even if it’s not as severe in the end.

Longer term rates increased last month back to basically where they were at the beginning on September.  Short term rates continued to drop last month by just a few Bps.   Short term rates should continue to be low until the Fed changes their position, but at that point they should snap back quickly and dramatically.

The multifamily mortgage market has picked up as the year ends but not as much as you would expect given current rates.   Many borrowers are still sitting on the sidelines because of a concern about loan proceeds or just procrastination.  I maintain that borrowers will regret that they did not take this opportunity to lock in low rates even if it meant no cash out on the loan or investing additional equity.

Freddie and Fannie are still leading the market.   Freddie has been particularly active with their CME product which has been pricing lower than a typical Fannie deal.   Also, in Fannie pre-review markets Freddie seems to be winning good deals by providing more leverage than the typical Fannie lender.  Many Fannie lenders are being aggressive and offering higher proceeds than Freddie in non pre-review markets.  One thing to note however is what Fannie lender you are working with.  Some Fannie lenders are aggressive today, while others are relatively conservative.  Working with a good broker may help you determine which Fannie DUS lender is the right one for your property.  Actually, that’s always a good idea.

Life Companies are still lending, but only conservatively and HUD is still busy.  HUD rates have risen over the last month, but are still very attractive.   The issue continues to be capacity and making sure you are working with a good HUD lender.

Banks continue to be an important part of the market.  Many banks are still lending especially on smaller properties.  However, the players are constantly changing.  It’s hard to tell which bank will do any particular deal so you must shop around.  This is especially true for borrowers whose relationship bank has abandoned them.  Borrowers with longstanding relationships are getting their banks to offer good deals.  However if you don’t have a relationship with a bank that’s still lending you need to create one.  Don’t just ask for a loan, explain to them you need to establish a new relationship and will bring deposits and operating accounts with you in order to make the loan attractive.

The difference between 30/360 and actual/360 and why should you care?

Do you know how your lender calculates your monthly payment ad amortization schedule.   Its not as simple as you think.   In fact your lender may be calculating your payment differently than you expect or know.

A few years ago there was a lot of talk about payment methodology. People were talking about 30/360 payments, actual/360, actual/365 and all sorts of different methods to calculate your monthly payment.   From my perspective these various payment methods were just ways for lenders and brokers to hide the real deal and fool borrowers.  Today you don’t hear much about this issue, but its still an issue and one you need to understand in order to property evaluate your loan options.

For most of the 20th century, all lenders used a 30/360 calculation in determining your monthly payment.  They assumed every month had 30 days and each year had 360 days. This allowed for easy calculation of interest rates and amortization schedules. A 30/360 calculation is listed on standard loan constant charts and used by your calculator or computer in determining mortgage payments.

During the mid 1990’s the Wall Street lenders started using actual/360 or actual/365 payments in mortgages.  These are methodologies used in some other debt instruments sold on wall street.  These methodologies call for the borrower to pay interest for the actual number of days in a month. This effectively means that you are paying interest for 5 or 6 (on a leap year) additional days a year.  By doing this a lender can quote you a lower spread and rate on a transaction but actually collect the same or a greater amount of interest each year.    

The difference between actual/360 and actual/365 is the monthly payments not the overall yearly interest charge.  Both calculations charge you interest on the actual days in a month, but on the 30/365 loan your monthly payment is increased by the extra 5 (or 6) days of interest.  On an actual/360 loan the monthly payments are the same as on a 30/360 loan, but the amortization schedule is adjusted to account for the difference in interest.  Therefore, your balloon balance for an actual/360 loan would be slightly higher than for a 30/360 with the same payments. An actual/360 loan will have a balloon balance approximately 1% to 2% higher than a 30/360 loan with the same payment.

At current rates of about 6% the difference between an actual/360 or 365 loan and a 30/360 loan translates into about 8 Bps.  So in order to compare a 30/360 loan to actual/360 loan you should subtract 8 Bps or so from the 30/360 quote to put it in the same terms as an actual/360 or 365 quote. 

While the Wall Street conduit lenders started this trend, the Freddie Mac and Fannie Mae multifamily groups followed quickly behind.   Freddie and Fannie found they were losing deals to conduit lenders because of the quoted lower spread and its lower payment even thought he effective interest rate charge was the same or in some cases higher.  They started offering actual/360 loans in addition to 30/360 and today you can request a loan using either calculation.    Though the conduits are dead you still see most Freddie and Fannie quotes being offered as actual/360.    This is because it makes the rate sound better, lowers the monthly payment and makes it more likely the borrower will go ahead with the loan.   However this is not always te case so ask your lender what calculation method they are using.

While most Freddie and Fannie loans are being quoted as actual/360 this is not true of most other lenders.  FHA/HUD loans are quoted as 30/360 as are most life insurance company loans and almost all bank loans.   Therefore when comparing a Freddie or Fannie loan to a quote from another lender you must adjust for the payment methodology.

What’s the better methodology?  It really does not matter as long as you understand the difference.   Some people prefer actual/360 because it’s effectively a longer amortization schedule.  I personally prefer 30/360 because I can calculate the payment myself on my trusty HP 12c.  On an actual/360 loan I need an excel spreadsheet and still need to ask the lender for a printout of the actual payment and amortization schedule to make sure I am correct.   Whichever you prefer just remember to ask what payment methodology your lender is using so you can properly evaluate your loan quotes.

Interest only vs. amortization in today’s multifamily market

In the good old days, before the collapse of the CMBS market and partial failure of the banking system, interest only (I/O) loans were everywhere.  Banks were offering them, Life Companies were offering them, and Conduits were putting them on practically every deal as were Freddie and Fannie.   And it wasn’t only partial I/O, for the first year or two of the loan term; it was full term I/O, for the life of the loan.  The thought was that I/O improved the cash flow for the investor and with cap rates running at historic lows this extra cash flow was needed to support the value.  If you had to pay amortization then you could not support the debt service and still get a reasonable return.  Anyway, principal payments aren’t tax deductible so why pay them.   No one cared about principal pay downs because the values of these properties were going up so there was really no refinance risk.  

How times have changed.  For the most part banks have pulled back from I/O loans and, in fact, have generally shortened their amortization schedules.  The standard for banks doing apartment loans now is a 25 year amortization schedule.  Some banks are willing to stretch their amortization schedule to 30 years for a good deal or client while others are shortening the amortization to 20 (or even 15 years) for more risky loans.  Conduits have disappeared and most Life Companies are hiding from new loans, but Freddie and Fannie are still lending and still offering I/O.

First let’s talk about what they are offering.  Since both lenders have become more conservative they have also pared back their I/O offerings.  For 5 year loans, I/O is only available on lower LTV/higher DSC loans and typically for only the first 2-3 years of the loan term.  To get the full term, 5 years I/O you need to be 55%-60% LTV.   For 7 year loans the story is not much different, but a 65% LTV loan (in a good location with a good borrower) will probably be able to get full term I/O.  On 10 year deals (which are most of what Freddie and Fannie do) 2 years of interest only payments are available on most loans.   However, in order to get full term I/O you need to have a very strong DSC.

So interest only is clearly available for many multifamily deals.  However there is a big change from the “old days”, back then I/O was not really considered as a risk factor and I/O was free.   The CMBS bond investors did not require a higher spread for I/O deals so they must not be riskier deals.    While many lenders did personally recognize I/O as a risk, they had to play the game in order to get business so they did not price up for I/O and made these loans without a second thought.  Today lenders do recognize that I/O is a risk factor and offer it only on loans they think deserve it.  It’s no longer an automatic, but in general I would say Freddie is a bit more willing to offer I/O, particularly partial I/O, than is Fannie.  Lenders are also pricing up for I/O.   Fannie is generally adding 1-2 Bps per year of I/O and Freddie is adding 3 bps per year.  These are not exact add-ons and each deal is priced individually, but it’s a good rule of thumb.

So does it make sense for a borrower to choose I/O?  Let’s look at a couple of examples.  Below are two examples of I/O vs. an amortizing loan, one for full term I/O and one for 2 years of I/O, both on 10 year loans.  It’s clear to see that from a purely nominal dollar amount the amortizing loan makes more sense than the I/O deal.  On the full term I/O you save about $50,000 per year in payments, but have to pay back $815,000 more at maturity.  That’s over $300,000 of additional money you pay the lender over the life of the loan.    For the 2 year I/O deal the story is basically the same.            

 

 Full Term I/O

 

 2 years I/O

 

 

 

 

 Loan amount            $5,000,000               $5,000,000
       
 Amortizing rate (30 years)                   6.00%                     6.00%
 Amortizing Payment              359,730                 359,730
       
 I/O Rate                   6.20%                             6.04%
 I/O Payment              310,000                302,000
       
 Payment after I/O period                  361,275
       
 Total Payment savings from I/O              497,303                103,103
       
 Amortizing maturity balance            4,184,286              4,184,286
 I/O maturity balance            5,000,000              4,392,247
       
 Additional Maturity balance on I/O              815,714                207,961
       
 Total Cost Amortizing Loan            2,781,589              2,781,589
 Total Cost I/O Loan            3,100,000              2,886,447
       
 Additional cost of I/O loan              318,411               104,858
       
 * assumes a 10 year loan, 30/360 payment and 2 Bps per year add on for I/O

 But this analysis does not take into account every factor.  It does not account for the time value of money, basically a dollar today is worth more than a dollar in the future and it does not account for the different tax issues.  To do the analysis correctly you need to discount the actual after tax income from the transaction and run either a net present value (NPV) or Internal rate of return (IRR) on your investment.  I focus more on the IRR, but both methodsare valid.  If you look at a sample investment with these example financing options you find that the amortizing loan has a slightly better IRR than the I/O loan.     If the rate for the I/O loan were the same rate as the amortizing loan, as it had been in the recent past, then, the I/O loan is a better option.  In my examples the break even for the two deals is about 2Bps per year for I/O.     This is about the charge for a Fannie I/O loan, but below the Freddie cost.  Therefore for a Freddie deal the I/O option may not be as attractive, from a purely finanncial stabdpoint, as their amortizing loan.

Actually the best deal in today’s market is the partial I/O loan.  A 2 year I/O offers the best of both world’s with some amortization to take care of the refinance risk, but better cash flow in the first few years.   This loan yields the highest IRR of the three options.   If you do take this choice be aware of the risks.  Your payment will increase dramatically at the end of the I/O period.  That payment shock is something to keep track of because once you get used to the higher cash flow generated from a low debt payment it can be hard going to the higher payment.

There are other factors to consider in choosing I/O.   For many owners who are raising funds from investors the I/O deal is better.    Investors get better initial cash on cash (CoC) return (which are what investors mainly look at) so even if the overall IRR or NPV is the same or worse doing the I/O deal may make sense.    On the other hand a full term I/O deal is assuming the properties value will increase over time or you are borrowing initially at a low LTV.   Borrowers who choose full term I/O a few years ago are having trouble refinancing and may loose their property because their mortgage is ballooning at the wrong time.  The markets won’t let them refinance because of lower property values and/or more stringent financing criteria.   If their loans were amortizing they may have had a better chance to refinance or work out the loan with the existing lender.

As I said earlier this analysis needs to be done individually on each transaction.  If you are looking at loan options and want assistance with that analysis or are you don’t know where you can get an interest only loan please feel free to e-mail me to discuss your situation (aklingher@mfloan.com).


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