Executive Summary
Lenders are preparing for significant foreclosures on income properties. Their greatest risk is with “bullet” loans that require a balloon payment. There is a real possibility the property may not qualify for a refinance due to marginal Net Operating Income (NOI, Debt Coverage Ratio (DCR), or Loan to Value (LTV) issues. This situation is complicated by signs of softening rents in many (but not all) areas. Recognizing the risk of foreclosures, lenders have put in place two remediation programs. One is Global Cash Flow (GCF) and the other is Debt Yield (DY). Last month we discussed Global Cash Flow. This month we address Debt Yield.
Foreclosures Up
The thing our entire industry – lenders and borrowers, buyers and sellers – is facing is how to do lending when interest rates increase. That’s “when”, not “if”. For a variety of reasons, many banks expect a much higher foreclosure rate. A friend holding a management position in commercial lending at a large nationwide bank told me recently that her bank expects to foreclose on a lot more apartments as rates bump up. Well, you just don’t hear something like that and respond with, “Would you care for another cucumber sandwich?”
There are several reasons for her employer’s concern. We’ll talk about some of them, but not in any particular order. The macro-economic environment is so unsettled just now that it would be a disservice to suggest that one possibility is likely while another is remote. We just don’t know what might happen; only that something will. After we’ve discussed some of the possible causes of a forthcoming higher foreclosure rate we’ll talk about what some lenders are doing about it.
Amortization
There are two common types of loans: fully amortized and partially amortized. Fully amortized mortgages generally run for 30 years. The interest rate is (often) fixed for the first several years of the loan period, after which it flips to adjustable for the balance of the amortization period.
From a borrower’s perspective, the most critical item with a fully amortized loan is whether the payments will be affordable after the fixed rate period. This is largely, but not exclusively, a management issue: the Net Operating Income must be enhanced. Rents have to be kept at full market values. Fixed and variable expenses must be reduced as appropriate. Fixed expenses are those that do not vary with building occupancy. Insurance, for example, should not be automatically renewed every time. How do you know you’re getting a good quote? Put the insurance up for bids at each renewal period. Variable expenses, such as maintenance, adjust with occupancy. An apartment building is going to have larger maintenance expenses when each individual apartment is packed with 10 tenants than when it has only two.
Partially amortized mortgages are like their fully amortized cousins except the balance of the loan is due before it’s fully paid off: think of a loan that is amortized over 30 years but due in 10.
Balloon
Generally, ten years in to a 30 year amortized mortgage the loan is 20% paid off. You’ve made payments for 33% of the entire amortization schedule yet have only paid the loan down by 20%. That’s because, as we know, the early payments go almost totally towards interest and only a little bit goes towards principal reduction.
It is not certain that the 10 year balloon can always be paid off through refinancing. Hypothetically, consider a borrower who’s purchased a property generating $6,000 monthly NOI. His loan is for 30 years but due in 10. The purchase price was $1,500,000 at a 5% cap rate (rounded). The original loan amount was for $1,000,000 at 4.5% interest. Payments were $5,000 monthly (rounded).
Ten years pass. He’s managed to keep Net Operating Income even with 2% inflation and he’s now receiving $7,300 monthly NOI ($6,000 compounded at an average of 2% annually for 10 years).
Maybe Can’t Refinance
The note comes due after 10 years and he must refinance $800,000 (80% of the original loan amount) and (projected) interest rates are at 8%. Monthly payments would be $5,870. This doesn’t look too bad, does it?
But if we drill a little deeper we find problems. One big problem can sometimes be overcome, but numerous marginal issues frighten lenders and make the refinance have less than a 50% likelihood that it will be approved by the loan committee.
1: NOI – The minimum NOI necessary to support the new loan of $800,000 is $7,300 ($5,870 times 1.25 DCR). That means that the owner is just (barely) making the hurdle. If for any reason interest rates were higher or NOI lower, the refinance would be in jeopardy.
2: DCR – The Debt Coverage Ratio was 1.25 upon purchase and assumed to be 1.25 a decade later when refinancing was necessary. If the DCR was more than 1.25 the refinance would be in jeopardy.
3: LTV -At the time of purchase, the owner put $500,000 down (33%) and secured a new mortgage for 67% of the purchase price. But property values fluctuate, and the building will be appraised before the lender commits to a new loan. One of the ways an income property is appraised is by the income approach, and that depends heavily on market cap rates.
Since interest rates are higher it is reasonable to expect that cap rates would be greater as well. Originally, at the time of purchase, the property was priced at a 5% cap rate (slightly over the interest rate on the new mortgage). If we presume that 10 years along the cap rate matched the interest rate (8%) the building’s indicated value would be about $1,100,000 ($87,600 divided by 0.08). At a 70% LTV the maximum loan amount would be $770,000.
The above indicates that the owner of this property might not be able to refinance to pay off the balloon. Of the three items addressed, the NOI is marginal; the DCR may or may not be 1.25, and the appraised value would have to come in at $1,200,000 or more to make the standard 70% LTV (maximum LTV would be 75%). requirement. This would be a difficult loan to fund. But there’s more.
Softening Rents
A few months ago (Dec, 2014) we discussed that the observer can often tell what the Fed sees as their major economic problem by watching what they do with interest rates. Inflation is approached by increasing rates and deflation by lowering rates. Since 2008 many central banks (including our own Federal Reserve) have been lowering rates to fight deflation, eventually bringing interest rates (as reflected in money market yields) to very nearly zero, and in some cases below zero. The Japanese two-year notes, for example, are yielding a (minus) 0.04%.
A characteristic of deflation is that prices decline. This includes rents. So the lowering of rents is now on the radar. Some areas will be hit much worse than others, but there has already been some minor softening in the overall rental market (units stay vacant longer, rent increases are smaller or nonexistent, some buildings are accepting lower quality tenants). The impact is not yet serious and in most places rents seem to be pretty stable at the moment. But that’s expected to change.
So here we are in 2015, after eight years of fighting deflationary trends, and we discover that perhaps rents won’t be going up as much as expected. Maybe they’ll just stay the same. Even that will significantly impact loan values when rates do go up.
Many of those balloon loans made in 2007 are approaching their due dates. What happens when rents have not gone up as much as expected? What happens when a loan made at (hypothetical) 3.5% adjusts to 8% or more while rents are stable? A million dollar loan at 3.5% (30 year amortization) originally had monthly payments of $4,491. Say ten years go by, the balloon approaches, and the loan has to be refinanced at whatever the rate might be in 2017 or 2018. At a hypothetical 8% interest the monthly payments would rise to $7,338. That is nearly a 63% increase.
People live, in whole or in part, on the cash flow from their properties. A $3,000 (rounded) increase in monthly mortgage payments on two or three properties may not be affordable. And that is why many lenders have embedded Global Cash Flow filters in their loan approval process.
We talked about Global Cash Flow last month (Feb 2015). Global Cash Flow is a filter lenders are beginning to use to protect themselves against borrowers defaulting from payment shock when interest rates are reset.
GCF Review
To review, a lender using the Global Cash Flow filter will decline a loan if the principal and interest payments consume 100% of the building’s NOI. This part is not new. There has to be a little bit left over from the net operating income for unexpected contingencies. The way the maximum P&I payment is computed is the NOI divided by (example) 1.25 DCR and the answer is the maximum payment allowable.
But now Global Cash Flow extends that 1.25 debt coverage ratio to the borrower’s entire economic life. To qualify for a loan under the GCF umbrella the borrower’s total financial obligations (including a cash support allowance for each dependent) cannot exceed 80% (100% divided by 1.25) of his income. For a fuller discussion, please see last month’s article.
Debt Yield
Global Cash Flow is not the only “affordability” filter. A few lenders are using Debt Yield, which focuses only on the building being purchased / refinanced. These lenders do not care about other obligations the borrower might have. It is much simpler than GCF. This is how DY works.
Under the Debt Yield program, the loan application has to pass two filters:
- The maximum dollar amount the DY lender will lend is 75% of the property value. Over time the LTV can be expected to fluctuate, but right now 75% is a good working example.
- Regardless of the LTV, the maximum loan amount cannot exceed (for apartments) 8 or maybe 9 times the NOI, depending on the age and quality of the building. As the economy moves through its cycle, this ratio will probably fluctuate.
Takeaway
Lenders have selected the remediation program (singular) best fitted to their needs. Some have institutionalized Global Cash Flow. Others have elected Debt Yield. The borrower has no choice in the matter (other than applying at another bank). The good news is that it’s binary: one or the other. The borrower needs to qualify under only the program in effect at the lender he’s applying to. There is no move afoot (right now) to require the borrower to qualify under both GCF and DY filters.
This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.
Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected]
If you’ve missed some of the prior articles, basic guidelines on successful investing are in my book “Stairway to Wealth” available at www.LuLu.com