Thursday, June 11, 2009

CRE Interest Only Revisited

Barry Ritholtz at The Big Picture has a good post today on  interest only CRE mortgages (although I think he got one thing wrong, as discussed below). Interest only structures were very common during the boom. Sometimes loans were IO for the full term, but more often the loan was IO for a two, three, or five year period, so many loans made at the peak are seeing 15% –20% increases in payments now as the IO period ends. From Barry’s post:

“Investors in bonds that packaged $62 billion of debt for U.S. offices, hotels and shopping malls are bracing for more loan defaults through 2010 as Bank of America Merrill Lynch says landlords’ monthly payments may jump 20 percent or more.

Principal is coming due on the so-called partial interest- only loans as an 18-month-old recession saps demand for commercial real estate. About $179 billion of such loans were written between 2005 and 2007 and bundled into bonds, according to data from Bank of America Merrill Lynch.

With soaring vacancies and falling rents, some cash- strapped borrowers will fail to cover the higher costs, said Andy Day, a commercial mortgage-backed securities analyst at Morgan Stanley in New York. About 87 percent of mortgages sold as securities in 2007 allowed owners to put off paying principal for several years or until maturity, compared with 48 percent in 2004, Morgan Stanley data show.”

I think this is where Barry goes wrong:

Almost by definition, when a borrower users I/O financing, it suggests they cannot afford to make the actual purchase, and were unable to arrange other forms of financing.  Otherwise, the buyer would have arranged for to a less risky structure that is not dependent upon subsequent credit availability.

IO in CRE was not about maximizing affordability or leverage – although the actual payment was interest only, loans were still underwritten assuming amortization, so the loan amount was the same for IO and amortizing structures. Partial term IO structures were about boosting cash on cash returns in the early years of the deal. Here’s an example:


Most of us think of amortization as a small piece of the payment, but when rates are very low (like today) amortization is a very big expense component:


By deferring this expense for a few years a spreadsheet jockey could show a much better return in the early years. Combine that with rosy income projections in later years, and buying CRE at a 5% cap rate starts to look like a good idea.

I discussed IO in much more detail in my post “The Problem with Interest Only” last December. I don’t see a lot of defaults triggered solely by amortization kicking in on these deals – the easiest modification in the world is to extend the IO period, and I think we will see a lot of that going on. The underlying deterioration in cash flow and values is the much larger issue.