Five Reasons the Lowest Interest Commercial Property Loan Offer Might Not be the Best Deal

It is easy to focus on interest rate when choosing a commercial mortgage for a retail, office, industrial or multi-family property and miss other provisions that affect the borrower financially.  Here are five issues to consider that can make a commercial property loan with a slightly higher interest rate the better deal.

  1. Restrictive Prepayment Penalty – In general, the more restrictive the prepayment penalty, the lower the interest rate. Commercial property loans generally have one of three kinds of prepayment penalties – Step Down, Yield Maintenance or Defeasance. Step down prepayment penalties are fixed penalties expressed as a percentage of the loan balance being repaid. The percentage drops every year or two. For example, for a five year fixed rate loan the prepayment penalty is often 5% in year 1, 4% in year 2, 3% in year 3, etc. Yield maintenance and defeasance penalty calculations are complicated but their objective is to compensate the lender more fully for the lost interest income that would have accrued had the loan not been prepaid. Step down prepayment penalties almost always result in a lower penalty than yield maintenance or defeasance, except in situations where interest rates are increasing – in which case the borrower is less likely to want to prepay the loan. More often, a yield maintenance or defeasance clause will make it cost prohibitive to refinance prior to loan maturity.  Unless the borrower is certain they will not need to refinance or sell the property prior to loan maturity, they should consider paying a slightly higher rate and having the flexibility of a step down prepayment penalty.
  2. Short Amortization – Commercial mortgages most often have an amortization of 25 or 30 years, although, shorter and longer amortizations are not uncommon. The amortization has a big impact on the monthly payment and hence the cash flow from the property. A $1 million dollar loan with a 25 year amortization and a 4% interest rate will have a payment roughly $500 greater than the same loan with a 30 year amortization. If the borrower is looking to maximize free cash flow from a property, a higher interest rate on a 30 year amortization may be a better fit than a lower interest rate on a 25 year amortization.
  3. Required Impounds for Insurance and/or Taxes – Some commercial real estate loans require impounds for insurance and/or property taxes. The lender collects an amount each month sufficient to make the insurance and tax payments when they come due. The borrower is therefore paying the insurance premiums and taxes well in advance of when they would otherwise. In effect, they are making an interest free loan back to the lender.
  4. Loan Term With Narrow Refinance Window – Commercial real estate loans either come due at the end of the fixed rate period of they convert at that time to a variable rate loan. The latter are often referred to a hybrid loans. For example, a hybrid loan may have a fixed rate of interest for 7 years, after which the loan converts to a variable rate loan. Other loans have fixed terms equal to the term of the fixed rate. In the above example, the rate would be fixed for 7 years and due in 7 years. The rates on hybrid loans are a bit higher. But they offer more flexibility as to when the borrower refinances. A loan that becomes due at the end of the fixed rate period may force the borrower into refinancing at a time when interest rates are up or there are other issues with the property or the borrower’s finances that make refinancing difficult.