Among many things, the pandemic made us realize how incredible technology is and also what an absolute pain in the ass is can be. Office workers left the highrise in the CBD and sat at home in their slippers petting their labradoodles and smiled on Zoom while marvelling at the efficiences that technology provides us all. We could suddenly park the car in the garage, sip our chamomile tea and be efficient with our work. Technology works great, right up until the dog trips on the power cord, the internet goes out, or a coworker stands up on a Zoom call with no pants on. Technology is great right up until it isn't.
Loans and leverage are very similar. We are in a period when beginning investors are starting to realize this very concept. Many took out variable loans during the ZIRP (zero interest rate policy) years and underwrote the property as if interest rates would never rise. According to Moody's Analytics, approximately $1.5 Trillion (with a "T") worth of commercial real estate mortgages are set to mature by the end of 2024, and there is little comfort from the Fed in reversing course anytime soon. A loan is great right up until it isn't.
When investors consider risk, many look to financial metrics such as IRR or UYOC (unleveraged yield on cost) to determine the amount of risk to take on. Banks look at debt coverage ratios or loan to value estimates to help reel in investor expectations, but sometimes future projections can be rosier than they appear. Furthermore, when considering a loan, many investors will look only at which has the lowest interest rate or provide the largest cashflow. Interest-only loans and short balloon payments can look attractive at first, but not every property can give enough equity to make it through the tough times; as we're seeing now. Investors need to align their risk, business plans and their loans. So how do we do that and what do we look for? Here's a few items to consider:
DSCR - Debt coverage ratios need to be realistic. Does your anticipated income match the DSCR requirements and what happens if income projections don't materialize? What if rents run flat? What if they decline by 10%? What does that do to cashflow? Run scenarios to understand your leverage risk. We run best/likely/worst scenarios to match our risk profiles with our loan obligations.
Fully Amortized vs Variable - Once again, variable rates are great until they aren't. Are you sacrificing security for cashflow and what does that look like if interest rates rise? Once again, run those scenarios to see how much room you have and if the risk is worth the reward.
Balloon payments - Understand the difference between amortization and loan term. If the loan is amortized (meaning the payments are spread equally over the amortization period) but there is a balloon payment or term of 5 years, you need to be prepared financially. When that time arrives, you either have to refinance the loan or sell the property. Ensure you have a strategy for both and that it aligns with your holding timeline. Also, if you opt to refinance, consider that the loan terms will differ from today's and you may be put in a position of negative leverage or increased equity participation.
Prepayment penalties - These fees can be a counterbalance to lowering interest rates. Be aware of these fees and how they may affect a refinance in the future.
Effective interest rate - The stated interest rate is what everyone looks at, however it's not your real cost of capital. To understand that, you need to figure out the effective interest rate by including other costs such as points/fees, prepay penalties, lender participation, and shortened loan terms. Get to effective rates so you can better compare loans.
Bottom line is make sure you view your leverage as risk and align your goals.
Well, if you've read this far, then your dog hasn't pulled a cord, the internet provider is doing their job, and no one ran their car into a power pole. Technology is great. Just like loans.