Thursday, December 25, 2008

The Problem with Interest Only

There are a lot of CMBS interest only loans out there. Deal Junkie cites some numbers from REIT Wrecks:

Scheduled maturities of fixed-rate CMBS debt reach peaks of $98 billion in 2015, $128 billion in 2016 and $127 billion in 2017. 65% to 85% of those loans are interest-only for the entire or partial term. As for the near future, 80% of the loans maturing in 2008 and 2009 have been amortizing over the full term, significantly bettering the odds that these loans can be refinanced.

I’m not a big fan of interest only for reasons discussed below, but I think the focus on the higher refinance risk of IO loans is misplaced. To make my point, let’s look at what happens on a typical deal with a 10 year term and a 3 year interest only period. Here is the math:


The first thing to notice is the IO payment is 19% lower than the 30 year P&I payment. Obviously, a lower payment could be used to justify a higher loan amount, but to my knowledge in the CRE world people underwrote on the fully amortizing payment (this was apparently not true in the residential mortgage world). With CRE, the goal of the IO structure was to increase cash flow during the early years of the deal which resulted in a higher IRR for the borrower, and not to obtain a larger loan amount.

Next, notice in year 3 when amortization kicks in, the payment increases to 4% more than what the payment would have been under the 30 year amortization deal (because the loan has to fully amortize over 27 years instead of 30). 4% is not a big increase – it’s reasonable to expect operations would improve enough over a 3 year period to handle that (and, it was fairly common for lenders to agree to use a 30 year schedule at the end of year 3 anyway, so there would be no increase at all over what the payment would have been had it amortized from the beginning). The new payment amount is 29% higher than the IO payment was, but again that shouldn’t make a difference because the deal was originally underwritten assuming the amortizing payment. Here is a chart showing how the payments change:


(click to enlarge in a new window)

As long as the loan was underwritten to the fully amortizing payment to start with, the impact of the IO structure on payments is minimal.

What about refinance risk? The UPB on an IO loan will be higher than a loan which amortized from the beginning, but in the grand scheme of things there is not that big a difference. Here is a chart of the outstanding UPB of a 30 year amortization loan and a 3 year IO loan over the first 7 years:


(click to enlarge in a new window)

There is not a huge difference. Via The Big Picture, the NYT has a great training video from World Savings showing a loan broker explaining to a borrower what an idiot she is to worry about amortization:


(click the NYT link and scroll down to view the video). The irony is, he’s right; what happens to the market during the loan term is much, much more important than the amortization.

So why don’t I like IO loans? My concern is a tactical one, and relates to what happens if there’s a downturn during the IO period (like now, for example). When cash flow starts to approach breakeven owners get more attentive to their properties, and I believe that 19% payment difference between IO and amortizing payments results in IO borrowers being less focused during slowdowns. Also, if things get really bad one of the easiest modifications to do is to go IO for a while; there’s no loss to the lender, and the deferred principal is recouped at the balloon. If the deal is already IO, you don’t have that tool.