Before you can analyze the merits of a for-sale listing you need to have a basic understanding of the property’s numbers. By that I mean you need to thoroughly understand:
- How a property is valued
- How a loan amount is calculated
- How a property’s cash-on-cash return is calculated
- How loan amortization impacts a property’s cash-on-cash return
- How leverage (the amount of debt borrowed to purchase the property) affects a property’s cash-on-cash return
“In your sleep”
You not only need to know the importance of these numbers, but you need to know how to do these calculations “in your sleep.” They need to become second nature to you.
In the first part of this five part series we discussed how a property is valued. In the second part of the series we discussed how the loan amount is calculated. The first two CRE metrics admittedly were very basic but absolutely necessary for a foundational understanding of CRE underwriting. The third part of the series, how a property’s cash-on-cash return is calculated, was an introduction to that topic. It was anything but basic. We discussed the important difference between Return on Investment and Return on Equity. I recommend that you review that article before proceeding with today’s discussion on loan amortization as the cash-on-cash return example provided in the previous article is carried forward into today’s presentation.
CRE METRIC #4 – HOW LOAN AMORTIZATION IMPACTS A PROPERTY’S CASH-ON-CASH RETURN
Amortization is the gradual pay down of a mortgage with regular payments over a specified period of time. The loan amortization period sets the amount of periodic payments required to pay off a debt obligation. Each payment is used to pay interest on the loan and reduce its principal. That is a textbook definition of amortization. However financing commercial real estate has a few unique caveats that need to be mentioned.
Almost all commercial real estate loans are bullet loans. A bullet loan is a loan that requires a balloon payment at the end of the term. A typical real estate loan is a 10-year fixed rate loan amortized over 25 or 30 years. At the end of the 10th year the loan is due and the principal balance must be paid. So what does the owner do at the end of the 10th year to pay off the loan? He either refinances the property or he sells it.
As a result, very few commercial real estate properties are without debt. It really makes no sense to own a property free and clear because it adversely impacts your ROE. In other words, to optimize your property’s ROE, it’s typically better to leverage your property with a modest amount of debt than to own a property without any debt.
Actual/360 vs 30/360 Amortization Methods
Historically, mortgage payments have been calculated based on a 30/360 basis. In other words, it is assumed that each month has 30 days and therefore each year 360 days. This allows for easy calculation of interest rates and amortization schedules. Your calculator or computer uses a 30/360 calculation for determining mortgage payments.
Actual/360 payments became popular in the 1990s. Not surprisingly, it is a way to make an interest rate sound better than it actually is. This amortization method has the borrower paying interest for the actual number of days in a month. This results in the borrower paying interest for 5 or 6 additional days a year. A lender using an Actual/360 amortizing method can quote a lower spread and rate on a transaction but actually collect the same or greater amount of interest each year.
Interest Only Loans
To entice borrowers to borrow from them, some lenders offer interest only (I/O) loans. An I/O loan is a loan in which the borrower pays only the interest for some or all of the term, with the principal balance unchanged during the interest-only period.
It is not uncommon for lenders to offer two or more years of interest only with the remaining term of the loan being amortized. Why would borrowers like I/O? As you will see in the example that follows, I/O is a great boost to a property’s COCR during the interest only phase of the loan.
An Example of the 3 Amortization Methods
Shown below are examples of each type of amortization method. In each case, the loan amount is $684,000 and the interest rate is 5.0%.
To summarize the three amortization methods are:
- 30/360 – Interest calculated on 30 day months
- Actual/360 – Interest calculated on actual days in the month
- Interest Only – No amortization of the loan
Summarized above are the results for each of the amortization methods. Notice that the annual mortgage payments are identical for the 30/360 and Actual/360 amortization methods. But notice that the Actual/360 amortization method results in slightly more interest expense than the 30/360 amortization method. This is due to calculating the interest expense based on 365-day year rather than a 360-day year like the 30/360 method. More interest expense for the Actual/360 method means less principal pay down.
The Benefit of Interest Only Loans
But more importantly notice that the Interest Only/No Amortization method results in significantly less annual mortgage payments, $34,200 compared to $47,983 for either of two amortization methods. So let’s revisit the ROE calculation.
Recall that original Return on Equity (ROE) was calculated to be 3.8% based on cash flow after debt service (CFADS) of:
$60,000 NOI – $48,000 DS = $12,000 CFADS
That is true assuming the loan is amortized by either the 30/360 method or the Actual/360 method. But the CFADS changes significantly if the mortgage payment is Interest Only as shown below:
$60,000 NOI – $34,200 DS = $25,800 CFADS
With Interest Only the property’s ROE is:
$25,800 NOI ÷ $316,000 Owner’s Equity ($1,000,000 Value – 684,000 Existing Loan Balance = 8.2%
So which would you prefer? A 3.8% ROE or an 8.2% ROE? It seems like a no brainer to me. And that is why an interest only loan for the first couple of years should be preferred over an amortizing loan.
Those are my thoughts. I welcome yours. What is your opinion of interest only loans?
Doug Marshall, CCIM is the award winning author of Mastering the Art of Commercial Real Estate Investing. Check it out at Barnes & Noble.