WWYD: 5 year commercial at 5% or a 30 year fixed at 7.25%?

[Brie Schmidt]

I am not a economic expert or do I really follow market trends, so I would like advice from people smarter than me on this topic like @Ben Leybovich and @sean

We have pretty standard commercial financing on 1/2 our portfolio.  They are 5 year loans on a 25 year amortization at 5%

I really don't like these loans because in 5 or 10 years the rates could be double and I could find myself in an unpleasant situation.  

I just learned of a possible new loan program on commercial which would be a 30 year fixed at 7.25% 

The rate is obviously higher but to lock it in for 30 years would be fantastic.  

What would you do?

[Chris Simmons]

@Brie Schmidt 

I will weigh in since I have some familiarity with this topic.  I am a small investor that is about to close on my 5th single family property and make an offer on 2 quadplexes.  In that sense, I don't have much informational value.  In the sense that I am a commercial lender in the Special Assets department of a large, regional bank, I do have some value.  In my day job, I monitor risk for the bank and handle troubled loan portfolios.  I am the commercial banker you get handed off to when your previous banker either 1) senses trouble and wants to hand you off or 2) is forced to by senior management after a cycle of loan review due to various concerns.  I am the one that is tasked with getting the banks money back, enforcing the loan contract to the letter and typically filing suit against you.  But other than that, I am pretty nice.

You have two risks here. 

First, you primary risk mentioned is the interest rate risk.  Where are rates going?  The answer everyone agrees on is up.  It is just a matter of time.  Do what you want in terms of refinancing for interest rate risk.  I personally, while I still have my W2, am letting properties season and refinancing them to 30 year fixed, consumer type mortgages with rates below 5%.  By the end of the year, I expect to quit my job and do real estate full time and thus lose the financing options my W2 affords me.  That said, my wife still works full time and I can put some properties in her name if needed.  Again, this is just time value of money and an investment expense for you to manage.

Second, and in my opinion WAY MORE IMPORTANT is your maturity risk. Just like the 3/2/2 is the bread and butter of suburban homes, the 5 year term, 20 year amm loan is the bread and butter of commercial loans. Here is the problem. Your lender might tell you that you will have no problem renewing your loans every 5 years. Appraisals will go up, debt is gradually getting paid down so LTV will look better and better each time. Ok.....sure...that makes sense. Assuming appraisals go up. And of course contingent upon your rental revenue staying steady....and expenses not outpacing revenue (interest expense is one of them). There are all sorts of metrics that us bankers rate you on. When times are good and competition is fierce, we approve policy exceptions, we turn the other cheek. When things go bad....recession, market collapse, bubble burst etc, all of a sudden, a bank's lending appetite will change. If your loan portfolio doesn't mature for another 3 years, they may not call your loans due (Lenders Right to Accelerate) unless there are significant issues. BUT....when it is time to renew and if you are not an absolute polished diamond of perfection with a portfolio they are still excited to lend against, your loans might not get renewed. All you are left with is that balloon payment that is likely now past due and you are caught in the worst form of loan default there is and stuck dealing with someone like me. No joke....the bank I work for made a change to credit policy several years ago after the latest downturn to no longer, unconditionally, without exception, no longer underwrite loans for single family - (defined as quadplex or less) that are not owner occupied for the life of the loan. We had too many investors walk away or otherwise default. As an investor, I was insulted but as a banker, I understood it. If a portfolio of 100 single family homes goes bad, that is 100 foreclosures, 100 potential evictions, 100 vacanct, potentially vandalized homes that needs listed with a realtor for sale in the next year or so. If the same investor had a 100 unit apartment complex...no problem. 1 foreclosure, put in a receiver, let it cash flow and sell it when the time is right. Are you sure your lender won't make the same policy decision to unconditionally exclude single family type properties from their commercial portfolios?

Now there are all sorts of strategies I can discuss with you off line to help mitigate this, but the best is simply to, and in this order, 1) get the longest possible maturity possible, 2) get the longest term fixed interest rate possible and 3) worry about amortization periods.  There is a portfolio lender in my area that I am talking to that will do a 20 year loan.  Again, that is a 20 year maturity so that I don't have to renew the loan with an appraisal, renewal and appraisal cost, credit app and updated financials every 5 years.  I simply don't default on this loan and I am good for 20 years.  The rate is fixed for 5 years and then can adjust as defined in the contract so it does not alleviate the interest rate risk, but you no longer have the maturity risk.  And it is still a 20 year amm so you have a more aggressive repayment structure compared to the 30 year amm you can get if you refinanced them with a consumer type lender the traditional way.

Message me if you want more info.  You already answered some of my questions previously.  I am here to help.  I just wanted you to be aware that interest rates might be the least of your worries if things go bad in the future.