A recent article in the Wall Street Journal asked the question, “Which are the most toxic [commercial real estate] loans?” It then identified interest-only loans made by banks and securitized lenders as “the most poisoned piece of the commercial real-estate pie.” The source of the Journal’s gastronomical observation was a Federal Reserve presentation made to bank regulators last month.
The article upsets me for two basic reasons. First off, you just don’t mess with somebody’s pie or suggest that it might be poisoned, particularly when we are heading into the pumpkin pie, pecan pie, cherry pie and all-American apple pie seasons of Halloween, Thanksgiving and Christmas. Pick another image, Wall Street Journal, and leave pie out of this.
From a business standpoint, the article upsets me because it focuses on a perfectly valid loan type, at least when used properly, and blames bad results on the payment terms rather than the underwriting.
According to the article and as the name suggests, interest-only loans or “IO” loans are where the borrowers pay only the monthly interest due but make no principal reductions until maturity. The following observations were made about IO loans:
“A lot of these loans were made at the market peak, get no benefit from amortization and have seen a decline of more than 45% in the values of the properties backing the loans, the Fed presentation notes. As a result, borrowers with these loans likely will [have] a hard time refinancing when they come due.”
The article adds that, according to the Fed presentation, the value-drops stem from the “evaporation of capital and a massive recalculation of risk within the industry” as well as “lower rents and higher vacancies,” which will lead to further value-declines in 2010.
If the Journal is quoting the presentation correctly, it bothers me further that the Federal Reserve and the regulators in attendance are blaming the commercial real estate industry’s problems on the lack of principal reduction. A quick review of the numbers will tell you that amortization would not have helped the situation.
Assume a property valued at $1,500,000 and a 75% LTV loan of $1.125 million on a 20-year amortization at 6.5% and a five-year balloon. By maturity the loan will have been reduced between 14% and 15% to $963,000 and the new LTV would be about 64% if the value remained the same. But a 45% reduction in value to $825,000 puts the loan underwater to start and gets worse when you apply the 75% LTV for a new or renewal loan of about $620,000. With or without amortization, this loan was doomed from the start from what was potentially an overly optimistic appraisal with — dare I say it — a “pie-in-the-sky” value. The problem was poor underwriting of the risks, not the payment terms.
I mentioned earlier that interest-only loans were a perfectly valid loan type, at least when used properly. In my mind, and using the above numbers for illustration, a $1.125 million five-year loan without amortization is probably a bad idea. You just don’t do an interest-only loan at the maximum loan-to-value for five years. I would, however, advocate interest-only for five years if the initial loan-to-value were lower at 60% to 65%, since that is where you would wind up after five years anyway. That is an appropriate use of the loan type.
In reality, I suspect that all banks will require some amount of periodic principal reduction, regardless of loan-to-value, since their regulators will want to see some level of amortization. But if you have a good story and solid underwriting with a low initial loan-to-value, go ahead and ask for interest-only. To improve your chances, consider offering your lender a nice apple pie. Couldn’t hurt.
(Brian Andrews is a certified mortgage banker specializing in the financing of commercial real estate. His business is Andrews Commercial Mortgage and he can be reached at brian.andrews@acmla.com.)
