Interest Only Mortgages

Mom writes:

Some day on your webpage you need to talk about [Interest Only]
mortgages. I know lots of cons but are there any pros[?]

Now, as stated in the title of this blog, I will have opinions the many things that I am eminently unqualified to talk. In regards to this particular question, I wouldn't go so far as to say "eminently", but I am by no means an expert. Based upon what I do know...

I responded:

Interest only mortgages are advantageous for only a certain select few, and for those few can be very advantageous. However, the availability of interest only has tarnished the reputation, gain simply because most getting them have no business having one. Two groups of people come to mind that the interest only would benefit. Since interest only mortgages are typically well below market rates for fixed mortgages and somewhat below ARM mortgage rates the cost alone would make it attractive to anyone, HOWEVER, I am of the firm opinion that the only groups of homeowners that should even think about getting one are those who have comfortable equity in their home (i.e greater than 20%) and are viewing their home as an investment ONLY or those who have the disclipine to continue to make a "fixed" type payment to capitalize on the lower interest cost. You should note that both of these types of people generally are more sophisticated borrowers and generally are at least upper middle to upper income borrowers.

Those of the first type, are generally planning on selling their home within 3-5 years and netting the gain as an investment to reinvested into another home. Why interest for these people? Because within 3-5 years the amortization schedule is still mostly interest anyway so why pay a higher rate, even if it is fixed? These people can generally see how much interest rates would have to rise for them to even get close to a fixed rate and are willing to take on the interest rate risk. Also note that these people can generally afford the traditional fixed rate mortgage payment, just choose not to use the payment difference on this particular investment (the home). These are true time value of money people. Money in my pocket now is worth more than later.

Those of the second type again can make the traditional mortgage payment...and do, that's the discipline (In other words, the payment made is of the same amount as one that is caluclated as an actual amotizing loan). They are smart enough to capitalize on the lower interest only payment while continuing to make the "whole" regular payment, which in turn reduces the principal balance faster. The forward risk is at what period of time should the homeowner decide to convert to a traditional mortgage, if ever? The real risk becomes hindsight because short term variable rates could eventually climb higher than what the homeowner could've fixed in at, say three years prior. One would think that the interest only interest rate will
always be lower than the then current fixed rate option, but to maintian the aggressive payment these people should augment their payment with addtional dollars if interest rates were to take a sharp spike.

Any person that doesn't fit these two discriptions has no business even looking at an interest only option. Unfortunately a lot do because it means they can get into something bigger than they can afford, and that's just a time bomb waiting to explode. But hey, the've kept up with the Jones's.

In all, I think Interest Only mortgages are just another ploy for brokers to go after unsuspecting individuals (or highly uninformed at least) to pad their pockets. These types of mortgages are not all bad, as evidenced by the types of homeowners that can benefit. However, I would bet money that the vast majority of homeowners that have this type of mortgage do not fit in the above noted demographic. For another day, another subject that pisses me off...Flexible Payment Mortgages.

Residential vs. Commercial Investment

Ok. Let's revisit a topic that I alluded to earlier: How do we value commercial real estate? It is quite simple really. The reason that I go here is that one really only deals with two types of persons in commercial real estate. The well seasoned, very successful property owner type, and the clueless asshat trying to get into commercial real estate.

The well seasoned person is especially easy to deal with, knows the ins and outs of commercial property, and more importantly, knows what the financing available is and what to expect. All in all, very easy to deal with.

The clueless asshat can be broken down into two subcategories: The clueless asshat who knows he is a clueless asshat and is open to suggestion and looking for advice on how to be successful, and the clueless asshat who has dabbled in residential real estate or owns a few rental properties and thus is a self proclaimed expert in real estate and consequently becomes the clueless asshat dickhead.

What does this all have to do with valuing commercial real estate? I'm going to tell you, but first some more backgrounding. The well seasoned group is generally older cats who have been around the block several times and usually have had their ass handed to them one or two times in the past, but have been resilient enough to come back. Real estate is what they do, real estate is what they know. Love these people. An absolute delight to work with.

The clueless group is generally younger, I would categorize as mid 30's to mid 40's, have been successful in other professions outside of real estate (not including realtors) and are now looking for investment options outside of equity and bond markets. Now, don't get me wrong. I do not mind working with this group either. It is just that my patience level is going to vary with how admittingly clueless one is. The admittingly clueless are actually quite easy to work with, when one has to...you see the barriers to entry are quite high and when the admittingly clueless finds out how much scratch he needs to come up with, um, I think I'll just go fix up some rentals.

So you really don't have may opportunities to really deal with a complete real estate novice. Every now and then, but not common. So really, most of the clueless group are the asshat dickheads. Why are they asshat dickheads? I thought you'd never ask. Most of these cats are currently real estate investors, but 99.9% are involved in residential real estate. These folks either have one or multiple rental properties, or, are "fix & flippers", i.e. buy depressed homes and invest 15 to 20M (remember, roman numerals) and then sell for about 20 to 30M profit. Most want to make the jump into commercial real estate because they have heard how lucrative it can be or just see how many more zeros are involved and translate that into more zeros in profit. Most realize how wrong they are when it's to late and they have already been poked in the rear end.

Granted, residential and commercial real estate are two different animals, but most of these cats really don't realize just how different they really are. We're talking different species here. The fundamental difference that most get wrong is how the money is made. In their previous lives in residential real estate, both of these guys (the rental guy and the fix & flipper) made money in capital appreciation. When one owns a rental home, you're very happy is the thing breaks even i.e. the rent payment covers mortgage, taxes, insurance, reserves for replacements, etc. chances are, the rent covers mortgage and maybe the taxes, but you're cool with that too. The little out of pocket for insurance and replacement reserve is more than offset by the equity the renter is building for you by making your mortgage payment, and, in most markets just by virtue of time your property is going up in value too. Our fix & flipper makes money on capital appreciation too, say (for sake of ease), purchases a depressed property for 100M, invests 20M in cosmetic improvements, and sells it for 140 to 150M. Pretty good racket if you ask me (probably why you see those "we buy ugly houses" signs all over the place).

Most are getting into these at a relatively low cost of entry, say, anywhere from 5% to 20% equity. On the higher equity requirement (mostly the rental owners) many will get a 2nd mortgage to pull that cash back out and invest in another property and pass the payment on to the renter if the market will support it. So in a nut shell, most of these guys make money with little to no money of their own into it, it's all about when they realize their profits. Make a note here: Residential Investment = Capital Appreciation. Or, the money made when the property is eventually sold.

Where the hell am I going here? When these guys attempt to make the jump into commercial real estate, they expect the same kind of treatment in regards to entry costs. No. No. No. First of all, equity requirements are at a minimum 25%, sometime more. A rule of thumb in this business that a commercial building cannot sustain more than 75% of its value based on current leases in debt. Come again? The value of a commercial property is based upon the income stream generated by its current leases (or market leases).

Por ejemplo: You have a 10,000 sq/ft building that is getting $10 per sq/ft NNN (Triple Net Leases = Taxes, Utilities & Insurance are paid by the tenant). So, to calculate a rough estimate of what the building is worth we annualize the revenue stream ($100,000) and then slice off 20 to 25% for vacancy factor, management, and reserves for replacements/repairs. Leaving us with a net figure (commonly referred to as NOI = Net Operating Income) of $75M. We divide this by 10% (remember, accurate and easy to do in the head) and we arrive at a value of $750,000. At 75% of this value, a loan amount would be $562.5M. At current market rates of 8% and 20-25 year amortization a monthly payment would be in the neighborhood of $4,400 - $4,750. Annualized payments of $52-57M. The property owner is therefore making $1,500 to $2,000 a month. Not bad, but definitely not support your family type income. In time this amount grows as the loan gets paid off and the monthly income stream gets bigger to where at retirement age the entire NOI is going into your pocket. Generally speaking, if one can get a small portfolio of these going, you'd have one heck of an annuity for retirement. The well seasoned guys get this. And are doing this.

The clueless crowd, thinking that they can leverage this to the hilt like their residential properties don't get this. At 75% we've determined a reasonable net income. You start increasing the leverage and the income stream dwindles or stops. Now I ask you, what's the point of owning an income producing property that doesn't produce income? The asshat will say, "well, I'm just going to flip it an a few years anyway". Huh? Unless market demand for leased space drastically increases in a few years (fat chance) the building is relatively going to be around the same value as when you bought it. Meaning, you'd probably make more money doing the "fix & flip". Make a note: Commercial Investment = Current Income.

Now, again keep in mind that there are a lot of other factors to consider, but this is the gist of it and generally speaking following this approach will keep your financiers happy. So you can take off the asshat. And quit being a dickhead because I won't let you get away with 15% in.

Underwriting The Transaction

One deals with loan brokers quite a bit in this business. I would have to say that it is one of the least desirable aspects. For those who are unfamiliar with brokers, in simple terms they are essentially a group (a large group at that) of people that link up lender and borrower. Some of them are good and have banking experience, most are not and do not. Very rarely do I come across a broker who specializes in commercial properties and only deals in that arena. Most are residential mortgage brokers who come across the random loan that they don't know what to do with.

Where am I going here? In the realm of residential mortgages (I am not an expert in residential properties and don't profess to be one, but it can't be that complicated can it?) the broker takes the loan application and submits it to one of many lenders looking for the best deal. The best deal being the best rate. The lenders pay the broker for the loan and make most of their money through servicing the loan (collecting and processing payments etc.). Think about it. How may times has your own mortgage switched hands? The broker will typically charge a fee to the borrower for placing the loan, and then makes money when they sell the loan to the lender. This is called making it on the back end. Now, there is more going on here than I know or care about, but this is essentially the gist. The point here is that the best deal is highly governed by the credit score of the borrower. This, from the lenders viewpoint is called underwiting the borrower.

When these residential guys come across the loan that they can't place with a mortgage lender (it doesn't fit in the box) they call me, the real estate guy. I can hear the way the conversation goes in my head. In fact, I have nightmares about it. Really? No, not really, but I still hate it.

Broker: I got a borrower here, he's looking to buy X (X being any number of properties that don't fit in the mortgage lender box).

Me: What's the purchase price?

Broker: He's got great credit.

Me: What's the purchase price?

Broker: Low loan to value.

Me: What's the purchase price?

You see why I don't like this. The broker is already trying to lead me down the path (albeit unknowingly) of underwriting the borrower. But you see, at this point in time I really don't give two shits about the borrower, and really, unless the guy has some real character issues I really don't ever care about him that much anyway. I want to know about the transaction. Hence, what's the purchase price? As soon as I get a call, I immediately start to mentally underwrite the transaction to see if it makes sense.

Let's dissect the above conversation on the brokers side. "I got a borrower here, he's looking to buy X"--Ok pretty straight forward. For the sake of discussion, let's assume X is a house that is no longer a house, but say, a photography studio. Why? Because since a house it's feasible that a residential guy would stumble onto it, but since it's not really a house a lot of his conventional lending sources won't touch it. Back to our conversation.

"He's got great credit"--Now, he just dodged my first question. I really don't care if he's got great credit. If he does, super, he takes care of his shit. If he doesn't, well, the reverse is true now isn't it?

"Low loan to value"--Now here's where I start to get irritated. First, he just dodged my question again. Second, I know exactly where he's headed. By telling me the loan to value, he's hoping to finance more of the purchase transaction. What do I mean? Example time again.

Pretend:
The house that's not a house is listed for $250,000.
The actual value of the house is $500,000 (we'll worry about why another time).

The buyer found a firesale here and is hoping to find someone dumb enough to finance 100% of the purchase based upon and appraised value. Ever hear of the patron saint of banking? Saint Happenin.

This is why I always start with the transaction first. If the transaction doesn't make sense, the numbers will never fall in line. I could get into more depth here, but its 5:15 on Friday afternoon and I think there's gotta be a bucket of Coronas looking for me somewhere.

Financing religion

I recently had a loan approved for the acquisition of a building for a church. In my years in commercial banking, these have to be my least liked type of loan to look at. Thankfully, these don't come around too often, but when they do, the response is always "Ohhhhhhhhh Noooooooo!" because they are really, excuse the pun, a damned if you do, damned if you don't type situation. You don't want to be the bad guy who turns a church down for a loan - but you really don't want to be the worse guy who foreclosed on the church when they can't make the loan payments.

Most congregations have funds collected years in advance sitting aside in a building fund to pay for the new building or new construction making this scenario all the more rare, but every now and then one comes along more American-like in the "buy now, pay later" sense. It would appear to be more prevalent in my area for a couple of reasons: the rapid expansion of the suburbs fueled by production home construction pressing for the immediate construction of new churches, and the escalating cost of ground acquisition. Makes sense really. Most groups will get permission to hold mass or service at an existing church of a different denomination, local school, or other community building until funds are collected to get moving on construction of their own church. This approach generally only lasts until they have accumulated enough funds to qualify for financing with some sucker (read: me).

Construction of new churches really isn't as bad as I make it sound to be, but it does need to be of major denomination, i.e. Catholic, Methodist, Lutheran, etc. This is because most major denomination have national and regional bodies that have funds available to loan individual parishes for new churches...They just don't want to be involved with the construction. This makes sense too, because so many things in construction can go sideways it's usually best to leave that for the ones who do it daily.

Problems arise when the regional body i.e. the Denver Presbytery, commits to a level of permanent funding (which in part is based on construction bids and finished value) and construction begins to exceed this amount. Church groups tend to not like setting aside additional loan funds from the original budget (called contingency funds) because greater commitment amount = larger fees, and that's understandable. But on a sideways construction loan to a church additional money comes from that little collection plate. Which, makes underwriting major brain damage.

When I underwrite a loan, two things really have to pass muster: cash flow and collateral. Or, in other words, ability to repay and security. Now you may have heard of the "5 C's" of credit, blah, blah, blah, but I really only pay attention to the two (the others are important, just not as). What becomes a headache is the cash flow coming from a church outside funds set aside in a building fund is from the collection plate. So I've got to analyze the number of households attending per service, amount of average contribution, probabilities based upon the likelihood of an additional collection for building fund through construction...it goes on and on. While this may not really bother me per se (I'm a bean counter at heart. I will now retire to the nerdery with my calculator), it all really comes down to tea leaves in water. They're all predictions and pro formas, and I'll be honest, I've never seen a pro forma (on any level) that didn't work out, think about it.

What bothers me about the whole process is that the feds are on our backs and require at least the semblance of an educated decision when the reality is that we're crossing our fingers that it comes in on budget to get taken out by the regional or national body. So the gymnastics are in vein. What am I saying? Maybe pass an extra buck or two in that collection plate this weekend because some banker just might get some better sleep.

Just For Clarification

In the future you might see me refer to numbers and amounts with abbreviations. Just to clarify:

Thousand = M
Million = MM

So, 1,000 would be represented by 1M. Likewise 1 Million by 1MM. Why? Because I'm lazy and I hate typing commas & zeros. Why M and not K for 1,000? I don't know. Because M & MM are both roman numerals and someone sometime a lot smarter and richer than me decided so. Deal with it.

Income Producing Property

I'm always amazed when someone comes into my office attempting to purchase a commercial piece of real estate and expecting to get a "consumer-like" loan. They look at me like I'm crazy when I tell them how much I'm going to require down.

Prospective Borrower: Gulp. 25%?
Me: Yes. Minimum. That number potentially could increase depending upon the property (location, condition, etc)
Prospective Borrower: That's a big number.
Me: 25% of a big number is usually still a big number.

You get how it goes. These days anyone can get a mortgage for something like 95% of the value of the home they are buying, and most major banks will lend them the remaining value of the home in the form of an equity line. Nobody really has to put anything in to the transaction, and any amount you do spend is usually recoverable because of these equity lines. I heard an ad on the radio the other day where one could qualify for an equity line up to 125% of the value of the home. *finger scratching head* The average home price in Denver is something like $260,000. To make a loan of 125% of the value would be to expect the average home in Denver to increase by $65,000 to $325,000 to get back to even. Yowza. Now I realize that the average life of a home equity loan is somewhere approaching 10 years, but that seems like a pretty big leap of faith as a lender to expect that someone would pay on a house that he is upside down on for 10 years and wait for his home value to catch up with his debt. Excuse me Mr. Bank Man, here are the keys. Have fun.

And don't get me started on the rates that he is getting this at.

And some people expect something like this when they buy a commercial building. Well, not quite that bad, but close. Let's go back to our conversation:

Prospective Borrower: I was hoping to put in 10%
Me: What are you smoking? Can I have some?

Here is where it gets interesting. I'm not budging on 25% equity, but many times banks will make loans based upon alternative equity. Or, pledging additional assets as collateral. This is where people can potentially get poked in the rear end. Almost always as a rule of thumb, a commercial income producing property will almost always, always, always make money at 75% of its value (ah, that 25% down makes sense now) or less. Again we have to think of the property as investment, meaning that it is non owner occupied.

Let's assume that I own a 15,000 sq/ft building that is commanding $20 per sq/ft. Gross revenues for the property are going to be $300,000 annually (15,000*20). Slice off 20% management, vacancy, maintenence and replacement reserves, and another 30% off the remaining number for general expenses we have a relative remaining NOI of $168,000 (300,000-20%=240,000-30%=168,000). Generally speaking, if you would divide this amount buy 10% you will be in the ballpark of what the building is worth. Why 10%? Because I can do the math in my head (you'd be surprised at how accurate this method is). So if the value of the building is roughly $1.7 million, a 75% loan would be represented by $1,275,000. This loan amortized over 25 years at 7% (Prime + 1.25%) has a payment of principal & interest of $9,010 round. With monthly net operating income of 14,000 (168,000/12) my money can cover my payment by about 1.55x, but more importantly I've got about 5 grand in my pocket monthly. Not bad. The math always works out.

But what if the equity isn't cash down. A lot of the time it isn't. I pledge another property, my Rembrandt, whatever. You start notching up that monthly payment, and pretty soon we are breaking even. So? So, what's the point of income producing property if it's not producing income? Guys that come into my office with plans like this looking for consumer type financing should stick to rental homes. Commercial property isn't going to appreciate just because you're holding on to it. Its value is in the income stream, so unless leases drastically increase, the building is going to be worth around $1.7 million, give or take.

The reverse is also true. What happens if the neighborhood takes a nosedive and the demand for space dries up? What if I can only get $15 per sq/ft instead the $20 previously? Using our mental gymnastics from above my building is now worth $1.26 million. Gosh, I hope I had some principal reduction from my original loan of $1.275 million, otherwise, I'm underwater. And my monthly cash flow sucks too.

What's the moral of this story? Lease income. You mean to tell me that just because I bought my building 3 years ago for $1.5 million it's not worth $2 million now? Well have your leases changed? No? Yep. That's what I'm telling you.

Commercial vs Residential Relationship

Shocker comments:

Nice post for your first, but I would like to post a question. What do you see as the relationship between the commercial realestate [sic] development and residential over the next few years (1-3)? I know you don't do residential, however, I know these two fields are related in that when there is a lull or boom in one it definitely affects [sic] the other. In short, what can we expect to see in the near future with commercial realestate when the word on the news is that the Colorado housing market won't necessarily go flat but will slow in the near future?

Good question. I recently heard the same regarding CO residential sales. One of the things that many mistake when discussing real estate is that residential and commercial are such different animals. While value for both are governed by demand, the principles behind that demand are distinctly different.

A lull in the residential market may have a stagnating effect in home prices and value. The concept behind this is simple: less demand = less new home purchases = downward pressures on prices. This is directly related to how residential real estate is valued: comparable sales. So more or less, Shocker is indicating that he doesn't think that residential real estate will level off and I cannot disagree, but the slowdown WILL have downward pressure on the values. Does that mean that the residential market will not continue to see appreciation? No. What the hell does this have to do with commercial real estate development?

Let's see if I can keep this from getting too wordy. Conceptually, think of any large scale suburban development. When the land is developed, subdivision fully recorded with infrastructure in and lots ready to build on, what generally occurs? Usually a major player i.e. KB Homes, DR Hortorn, Shea, US Home (There are literally dozens) buys up large tracts of land and begins production homes. The larger commercially zoned projects are sold off to commercial developers who then put in grocery stores and all the peripherals. Think of any grocery store anchored commercial project. Do you think that it is coincidence that there is usually a bank on the corner if not more than one? That is what I mean by peripheral.

These are the staples that coincide residential development. It is a classic cart & horse scenario. New suburban home buyers aren't going to buy in an area without at least the prospect of these, not amenities, but call them conveniences somewhere close to around the corner. Likewise, a commercial developer is not going to get a major grocery chain to purchase land or lease a building without at least the prospect of there being somewhere in the neighborhood of a few thousand new rooftops within a stones throw. That is why these types of developments go hand in hand.

To get the ball rolling, the homebuilders generally offer significant discounts on new construction before the conveniences are there, but they make it up on the back end by jacking the prices after they are in. As soon as there is sufficiently enough new construction going on the commercial follows pretty quickly. This would be an example of what Shocker comments on one effecting the other.

Now when the residential development slows, these large scale commercial projects will slow in turn, but there are still large pieces of commercially zoned property that will not, and are not intended to be developed until all the residential is built out. Such properties will have medical centers and other non-grocery anchored retail centers. There is also pieces of land for which we in the business call "infill". These pieces of land are sections cut off from the residential areas and zoned commercial but are much too small for major commercial development. These are my bread and butter.

They are generally land parcels of 5-10 acres that will house 4-8 commercial building sites, dependent on topography. These will appear in built out areas of the subdivision, where demand for small retail/services will warrant, say, a 15,000 square foot building with your standard tanning/nail salon, insurance agency, dry cleaner, small eatery, etc. The demand is there as consumers generally do not want to go through the brain damage of navigating the maze that the major anchored commercial centers have become. Not being near the major anchored commercial center becomes attractive to the prospective occupant because, here, the cost of space is less. Everyone wins. Mom can go get her nails done without having to fight for parking, nail salon has a close captive audience and a cheaper lease. If the developer knows what he is doing he always makes money so don't worry about him (or the bank for that matter).

To finally answer Shocker's question, a slow down in residential sales will not necessarily slow commercial development, because so much commercial development is dependent upon the demand for space, which is only created once there are finished rooftops in the area, REGARDLESS IF THE ROOFTOPS ARE BEING TURNED OVER OR NOT.

This is conceptually how it is done. There are obviously endless details involved, but at the risk of beginning a novel I'll leave it at that.

Not That Anyone Cares...

For a few years now I've been sitting on this sidelines reading blogs daily, enjoying the likes of Den Beste, Reynolds, Hawkins, LGF, and many numerous others (too numerous to even begin to list). I've kicked around the idea of blogging multiple times, but the big question always was: what the hell do I write about? The abundance of excellent commentators on almost any topic imaginable proved daily to be much too intimidating for me to even voice my unqualified opinion.

Of course, one day that obviously changed. Here I am. Working, frustrated that I seemingly always find myself re-explaining what is to me, a very simple concept. I work in real estate, financing real estate to be more specific. For my employer's sake, clientele, and my own I will remain anonymous, however, feel free to ask questions and I will answer to the best of my ability.

When I talk real estate, keep in mind that it is of the investment variety, commercial, or development/construction. I DO NOT KNOW AND CARE NOT FOR RESIDENTIAL MORTGAGES. The closest I get to that is a residential subdivision, again working with a developer not end user (buyer).

So I guess the point of this is to post on the things that most get wrong when dabbling or beginning their investing in commercial real estate and/or land. My experience is limited to Colorado, but conceptually should carryover to any market, dollars & cents will vary. Know this: commercial real estate and land development are as close to the wild west as I've ever seen. Cutthroat, mean and nasty. One either does it well or doesn't last. Those successful generally haven't made it a habit to get poked in the rear end on a daily basis.

I guess I'll end this by saying from time to time I may post off topic on things that are interesting to me: i.e. politics, current events, etc. I know that I'm not an expert. These are opinions nothing more. One more thing, my grammar is probably terrible. Deal with it.