Underwriting assumptions Refi in 5 years I/O terms

[John Blanton]

Currently looking at an investment as an LP and the sponsor is assuming a refi at the end of year 5 with a I/O term of 36 months.

To me this feels like they are doing that to juice the returns in the pro forma and errs on the side of being too aggressive. But I also am not an expert in I/O lengths lenders have given in recent history (last 10-15 years)

Do you feel the 36 months of I/O in five years is realistic or aggressive?

Knowing that is a loaded question, can anyone share insight as to what the historical I/O term lengths for agency and conduit lenders?

[Kevin Owens]

@John Blanton

**Assumes a conventional Freddie/Fannie loan...SBL is a much more detailed conversation. 

On the multi side as a former Freddie employee in underwriting and now a Freddie/Fannie originator, 3 years IO tells me it's likely a 10 year deal or longer. 3 years is typical, on 7 year paper it will tap out at 2 years (there are refinance test restrictions, etc...). The former details assume a high leverage loan (75/80% LTV). Most syndicators will use IO to boost returns, it is typical in the larger deal space. Full-term IO opens up at 70% LTV, but with COVID now about 65% LTV. Prepay penalty is what you should be focused on with a 5 year refi on a 10 year term. If the GP is using a 12 year term to boost a 3 year IO period, the prepay could be ugly if YM or STD DEF, depending on rates, which we cant forecast 5 years from now.

If a 5 year exit is the plan, you should consider floating rate paper, the exit is 1% (assuming Fannie/Freddie). Most don't go with floating rate paper because A) most dont understand it and B) they dont want unconformatable conversations with equity when the rates change but...you buy a cap and the cost of the cap plus the 1% exit can be less than the YM/STD DEF..no one is a fortune teller but most planned refis will embrace the floating rate deal if a 10 year term with 3 years of IO and refi out on month 37 (once IO ends) then recast the IO period with a new 10 year term and 3 years of IO. 

In short, embrace the 3 years of IO, learn to love it...I know the returns will.