As an investor who was able to maintain a portfolio through the Great Recession of 2006-2008, I can tell you with experience that the adjustable-rate mortgage was a giant contributor to the issues that followed. Investors and homeowners alike were being handed loans that included low equity and low interest rates. The possibility of a rate hike in the future was rarely discussed and often poo poo’d. When my husband and I bought a property in 2004, we were offered 110% financing on the property. “Won’t you need money to furnish and renovate it?” the lender offered. Luckily, we opted to finance at 95% of the sales price. We made it through this recession with all of our properties, mostly because of our lending frugality.

As Covid 19 shut down offices everywhere for weeks and months in 2020, the rumors abounded that commercial real estate would crash. “How would this play out?” I often wondered. Will most of the country magically work from home? As it turns out, about a third of the workforce continues to stay away from the office. Headlines are filled with companies demanding that their workers return to the office even now in 2024. The commercial landscape has definitely changed, although retail and restaurants have returned to a healthy spot nicely.

Yet the ugly, loud and smelly cousin of the adjustable-rate mortgage is now appearing at Christmases everywhere for investors who have commercial loans. Commercial notes have always been put together differently than residential loans. Commercial loans rarely allow investors to have less than 80% of the value of the property leveraged. However, since the value of a commercial property is almost solely based on the income of the property, investors and bankers alike have grown to love balloon payments and rate resets. Commercial borrowers tend to want to refinance their loans every 5-7 years. As property values go up, investors can make a nice, tax free return on borrowed money. As property values go up, investors cash out into new loan products and pocket the extra money as the value goes up.

When I first started getting commercial loans, the standard time for a rate reset was 7 years. Nowadays, that timeline is typically 5 years. For a loan with a balloon payment, the investor first chooses the length of amortization. This can range from 10-25 years and rarely goes any longer. Banks are typically quite flexible with shorter lengths of time (I have managed to get a commercial loan with a 7-year amortization without a balloon or a rate reset, but these loans are rare and quite painful as the payments are high). Built into the paperwork, signed at closing, reads the fine print as to whether the lender has chosen a 5-year balloon or a 5-year loan reset.

If an investor chooses a balloon payment, this means that he or she will be getting a new loan at the end of the 5-year period. The loan will be amortized as if the investor will keep it for 20 years, for example, but after 5 years, the investor still has 15 years left of payments The investor must at that time get a new loan. The new loan can come from the same bank or it can come from a different bank. The old loan is repaid in full and a new loan is issued.

With a rate reset at the end of the 5-year period, the investor would make payments based on the amortization, again we will use the example of 20 years. At the end of the first 5 years, the interest rate will reset. The investor will continue with the same bank, but the payments will either increase or decrease based on the current interest rate. For borrowers who hit a rate reset when rates are lower, there is a huge benefit in that the loan payments now go down, sometimes considerably. I had a commercial loan that was at 7.8% APR in 2009. Later, I was able to move to a rate of 6.8%. When rates are significantly higher for the borrower at the time of the rate reset, investors must scramble to cover payments that can be quite painful. However, they are not able to take more money with a loan reset. They continue to pay off the loan, so the principal part of the payment remains on the same trajectory. The interest portion of the payment is the only change to the monthly total and the new payment becomes set for another 5-year period.

As rate resets and balloon payments have begun to hit in the post Covid rate hikes, many investors have found themselves in trouble. Increases in payments have taken most or all of the profits for investors with simple rate hikes. For investors with balloon payments, lending has become almost impossible. As lending institutions have been in the rhythm of loans being repaid frequently on commercial notes, borrowers are scrambling to perform on their side of the bargain. Commercial lenders must receive these balloon payments in order to then lend to the next borrower in line. This has created an era of what borrowers are calling “extend and pretend” as lenders are forced to extend loans outside of the contract terms with all sorts of concessions like interest only payments. Borrowers are scrambling to raise capital as payments increase overnight and values are dropping as rental rates deflate. Even a small reduction in income can have large effects on the values of these properties. Keeping a commercial property that has a lower value and a higher payment is not an easy task.

Enter into the picture the new kid on the block, the DSCR loan. This acronym is short for Debt Service Coverage Ratio. Lenders have created a new product based on the income of the property alone. The income of the borrower is given much less weight (if any) on the lending. The other bonus to a DSCR loan over a commercial one is that the interest rate is fixed for the entire loan and the lender can take the loan out 30 years. Another great feature of this loan product is that lenders will provide these funds on properties in an LLC, so lenders like myself who want to close a loan on a property in an LLC are able to achieve a loan on a single-family residence or higher. Additionally, the interest rate and payments are fixed for the entire term of the loan.

Before you look for the link to apply for this great product, please allow me to drop the other shoe. The fees are higher on this product than a commercial loan. Borrowers typically see a 1% fee at closing for a conventional or commercial loan. This equals 1% of purchase price, which is a lot. DSCR loans average a 2% fee at the closing of the loan, and like the other loan products, this fee is built into the loan and borrowers will pay interest on the loan fee throughout the length of the loan. Keeping in mind that if the borrower has to get a brand-new loan at the end of a balloon period, they would again pay a 1% loan initiation fee, so it's easy to argue that this 2% fee isn't terrible considering the alternative. Borrowers who use hard money typically pay 1-2% of the loan amount when they take out the loan and also 1-2% when they pay it off, so a DSCR loan looks like a gift when compared to terms like this.

Another downside to the DSCR loan is that it does come with prepayment penalties. Lenders frequently sign for loans in high interest rate periods like this one and console themselves that they can refinance the loan at a later date when rates are lower. With a DSCR product, the lender must promise to keep the loan for a minimum amount of time (typically 5 years) and that if they pay the note off before that time period is up, they will pay hefty prepayment penalties. This allows the lender to easily sell the loan on the market and buyers of the note have some guarantee of their return on investment.

If you are an investor looking for a great loan product, keep the DSCR loan in mind. I have one and will most likely have more in the future if commercial lending standards remain tight. As a borrower who has already maxed out the number of conventional loans allowed, I am thrilled to have another option for borrowing on investment properties. Real estate works best when combined with a great lending product, and I believe this product is here to stay.