The roof is leaking, the boiler is about to explode, and your building's ten-year mortgage is coming up on its eighth year. Sounds like a good time to refinance; especially with rates still relatively low compared to your building's existing mortgage. You could pay off your high-rate loan, take out a new larger mortgage to cover the repair costs, beef up your reserve fund — and still end up with lower monthly payments.
That's what the board of the co-op at 220 East 87th Street did when it decided that its 43-unit building needed major work. "We had not refinanced in quite a while and the mortgage rates were so attractive, we thought that we would essentially kill two birds with one stone," notes board president Errol D. Griffiths. "We refinance, we get the money to cover the repair costs and we lower our annual mortgage. What could be better?"
What indeed? But where does a board in such a situation begin? Refinancing can be complicated, especially if you've never done it before. With rates low, the time to learn about the process is now.
Prepaying the Piper
Since everyone's mortgage situation is different, the first thing to do is decide whether refinancing makes sense at this particular time for your property. And, should you conclude that refinancing is the way to go, you need to familiarize yourself with a few basic terms so you can understand the financial lingo that will be hurled at you by bankers, brokers, property managers, and lawyers.
The prepayment penalty is the number one concern when refinancing any commercial mortgage. (Personal homeowner loans do not have such penalties.) The original bank that issued your underlying mortgage — that's a "first mortgage" in plain English — also attached a hefty prepayment penalty to the deal to prevent you from paying off the loan before it comes due.
Why? Because the bank or lender who originated your mortgage often sells the loan on the secondary market to quasi-governmental loan agencies like Freddie Mac and Fannie Mae. Or they're sold on Wall Street to mutual funds like Fidelity. "Lenders like us need to sell them so we can re-lend the money," says Paulette Bonanno, vice president and loan officer at the National Cooperative Bank. "That's a sound banking practice."
In other words, banks don't want you to pay off your mortgage before it is due because they stand to make a profit on your loan by selling it based on the guaranteed interest you're providing every month. "It all depends on what words we use," Bonanno admits, "but that's the general concept."
The other most important factor is the date your current loan matures. Depending on the type of prepayment penalty you have, the cost of getting out of your existing loan will usually decrease, the closer you get to maturity. For example, many loans have a declining percentage penalty. In that case, the penalty would have declined from the five percent at which they began to about one percent in the final year, says Patrtick Niland, president of First Funding Group, a mortgage broker.
On the other hand, if your existing loan has the more common yield maintenance penalty the cost to get out of your existing loan could be much higher. According to Glenn Grimaldi, senior vice president in charge of commercial lending at HSBC Bank. "It means if they prepay the loan during the term of their mortgage, then they're going to make the bank or whatever lending company they financed with [complete] on what they would have yielded. It's a 'make whole' provision," he explains.
Say your co-op has a ten-year, $1 million mortgage at ten percent and you want to pay it off in the fifth year. As long as the bank can reinvest your money at ten percent, there is no penalty. But if the difference between rates (typically measured by the U.S. Treasury bond market) is currently three percent, you'll have to make up the difference, because the bank can't reinvest the money you borrowed five years ago at the same rate. So on top of the million, you have to pay the three percent rate difference of the million for every year you are prepaying. In this case that's $30,000 times five years or $150,000.
"In some cases, the prepayment penalty is so severe [$1 million or more] that it really does not pay at this point to refinance," says Mary Frances Shaughnessy, a principal in Tudor Realty Services.
When does it pay to prepay? When the rates of the loan are low enough to offset the prepayment penalty and save you money annually, as well. "If your current rate is ten percent and your new rate is six percent that savings is going to offset the penalty in a couple of months," explains Grimaldi.
That was the case at the 68-unit 808 Broadway in Manhattan. The board refinanced its $3.4 million loan with two years left on the principal. The co-op took out a new loan for $4 million at 6.86 percent so it could replenish its reserve fund, replace the boiler, repair the roof, and redo the hallways.
"We did pay a prepayment penalty of around $69,000," says Joel Wittman, the property's board president and treasurer. "But given all of that we still set down more proceeds at a lower rate. And we're also saving $30,000 a year in debt service. So our operating budget is actually $30,000 less because of the lower rate even at a larger amount. So it was a 'win-win' situation." Whether you'll win out over your prepayment penalty is something your board will have to decide for itself.
Bursting Your Balloon
If your loan is close to coming due, you have no choice but to refinance. Balloon mortgages typically are loans with a fixed interest rate and a predetermined amortization schedule that is longer than the term of the loan. For example, a five-year loan might have amortization calculated over a twenty-five-year period. At the end of five years, only a small portion of the loan's principal (6 percent to 8 percent) will have been repaid. The remaining balance comes due (or "balloons") and must be paid off or refinanced with a new loan.
Ten-year loans pay off a little more principal but they, too, have balloons of 80 to 90 percent of the loan's original principal (depending on the loan's amortization schedule). The only way to avoid a balloon payment at the end of your loan is to structure your new loan as "fully amortizing" or "self-liquidating" with the loan's amortization period equal to the loan's term.
Where the big debate begins is whether to go with short-term or long-term financing. "When rates are low, you go long-term. When rates are high, you go short-term," argues Stuart Bruck, a mortgage broker for Time Equities. "Suppose that you locked in a rate today in the low sixes for a short-term mortgage. Well, four or five years from now, who knows what the mortgage rates are going to be? However, if you took a 25-year fixed rate mortgage today, you would know for 25 years what your mortgage rate would be."
Thomas Schissler, a mortgage banker at American Property Finance disagrees: "Because, at some point, the roof's going to need work, or the boiler is going to break, or the windows are going need to be redone and you'll just have to refinance again to cover those expenses."
Both Schissler and NCB's Bonnano agree that a debt-free co-op is fantasy. "Boards all have the dream of someday paying off the debt on the building," says Schissler. "It's because they treat it like it's their home [and not a corporation]. In reality, I don't think any of these boards are ever going to actually pay off their debt."
In short, don't treat your commercial mortgage like a retail or homeowners mortgage. "Debt is a tool you use," says Bonanno. "A co-op is a corporation. It's an entity that has a continuous life. And it has four goals: maintain the property, maintain the quality of life of the shareholders, and maintain and increase value and also keep costs down."
Tying up your building's capital in a long-term mortgage defeats those purposes, says Bonanno. "Use capital when you need it to serve your purposes as they arise. Shorter terms mean more flexibility, and in the long-run, they'll save your co-op a bundle of money."
Also, short-term money is cheaper. "You get the better rate, the shorter the term is. Ten-year money is cheaper than thirty-year money," Bonanno notes. "That's because whoever's lending thirty-year money wants a higher rate in order to lock it up for thirty years than someone who's only willing to lock it up for ten. It's the same way when you do a bank deposit. If someone wants to entice you into a five-year CD they'd better give you a decent rate, because if you think rates will be going up, you're not going to lock into five-year money right now."
Grimaldi agrees — to a point. "It really depends on the needs of the co-op and what capital needs they may have down the line. If they know that 10 years from now they're going to have a major capital project then maybe they don't want to do a 30-year loan."
But, like Bruck, he agrees that a dream rate locked in today for 25 years could benefit the building greatly if the building has also negotiated a line of credit or other secondary financing with its lender so it can deal with future emergencies and capital improvements.
Most banks don't do more than ten-year loans because, as Grimaldi explains, "they don't want to be in a commercial mortgage for any longer than that. They want to make their profit." But the quasi-governmental loan agencies of Fannie Mae and Freddie Mac do. "The benefit of doing a Freddie Mac 30-year mortgage is that if you think the money is cheap enough now, you could do a 30-year mortgage and you're able to get secondary financing with Freddie Mac on top of that mortgage," says Grimaldi, who sells and services both HSBC and Freddie Mac loans.
Freddie Mac and Fannie Mae loans involve more paperwork — for the broker. "There's nothing that the co-op has to do involving extra paperwork," Grimaldi notes. "You need the same basic information package from the co-op whether you're doing a loan with me, NCB, or Freddie Mac." In addition, HSBC will put their unrevolving line of credit behind the loan for the full term of the loan—something certainly worth considering.
Give Yourself Credit
Whether you've negotiated a 10-, 15-, 20-, 25- or 30-year loan, a line of credit is a good thing to include in your deal, especially if you decide to go long-term. "You have to make sure that your lender will give you a line of credit or agree to provide money for a line of credit or for a subordinate mortgage for capital improvements in the future," Bruck says. "Or to allow you to go somewhere else to get that line of credit."
The board at 808 Broadway did just that. In addition to the new $4 million, 15-year fixed rate mortgage that the co-op got, "we secured a $500,000 line of credit with HSBC bank," Wittman says. "And the rate is one point over 30-day LIBOR [London Interbank Offer Rate]."
LIBOR is a popular credit index used by banks today for short-term financing. In February, LIBOR was two percent. So that means that 808 Broadway's interest rate on their $500,000 credit line was three percent. Not bad, right? There's only one problem: credits lines can rise unexpectedly. Five years from now 808 Broadway might be paying nine percent on monies taken from that credit line.
"A line of credit is an expensive way of borrowing money," admits Schissler, "because it's usually a floating rate and you have no idea where the rates will be when you go to use it."
Grimaldi doesn't see much of a problem since the credit line, according to him, is almost certainly going to be less than whatever mortgage rates are at the time that you borrow against it. "I don't think, historically, 30-day LIBOR has ever been at higher rate than ten-year fixed money," says Grimaldi, "because it's 30-day money. It resets itself every 30 days."
One thing to make sure of when negotiating a line of credit is that it is "co-terminus" with your refinanced underlying mortgage. That is, it runs on the same term as the underlying debt. "If the first mortgage is a ten-year loan, my line of credit will be a ten-year loan," says Grimaldi as an example. "So you're talking about a ten-year revolving line of credit, so they don't ever have to get it re-approved, which is extremely good from the co-op's point of view. They can come back in year six and say, 'I'm ready to borrow $100,000.' Then they can pay it off and draw it again."
Just be aware that, in order to pay off that line of credit that you borrowed against for that boiler breakdown or roof repair, you'll probably have to assess the shareholders. "You only pay as you use it, but you want to make sure it's available," says Bruck.
Just a Second
In addition to having low-rate emergency funding at your co-op's disposal, you want to be sure that you can get a second mortgage from your lender should you need one. Typically, it is wise, and simpler to get your refinancing, line of credit and second mortgage from the same institution. Most banks prefer it that way and will work with you to give you the best deal all around.
"Let's say that you're in a long-term deal and something happens in five years and you need to come back for more money," says Schissler. "You can come back to me for more money and I'll put a fixed rate second on there. And then you'd see the combined interest rate between the interest rate and interest rate on the second. And that's what your total payment would work out to be."
But, what if you already have a second mortgage prior to your refinancing? "Normally, when co-ops come to me, they only have the one debt," says Schissler. "But if they had a first and a second, we'd want to pay off both because we want clear title. We want to be paid first. If we had to foreclose, we don't want anybody in the way with a claim superior to ours."
The co-op is responsible for paying New York City and New York State mortgage recording tax on all new loans. You already paid the recording tax on your existing loan, so when you go to refinance that loan you don't have to pay it again because your new lender will take the old mortgage by assignment. In other words, the old mortgage is being assigned by the old lender to the new lender. You are responsible, however, for the mortgage recording tax on new money that you're borrowing above the outstanding balance on your existing loan. If your current mortgage is $3 million, for instance, and you're refinancing for $3.5 million, you only pay the tax on the $500,000.
The one exception to the mortgage recording tax is if your new lender is the National Cooperative Bank, you will not pay the recording tax because NCB is exempt. This institution was formed under a congressional charter and the state cannot tax the federal government. The only catch here is that you have to buy stock in the bank, which is one percent of the loan. That's about half what the tax would be and the stock pays dividends, which is a nice plus.
Any co-op board planning to refinance should put together an information package to present lenders with a clear financial picture of the building. Your building manager will be invaluable here.
The list should include:
You should also be aware of what kind of work the building might need over the next five years and be prepared to pay a collection of fees over the course of the proceedings. Besides the fee to your broker or manager, you'll also be responsible for legal fees to your lawyer and the bank's lawyers. You'll also have to pay for a title search and insurance costs, the building appraisal, environmental reports (inspections for asbestos, lead paint, and fuel tank leakage) and the engineering report (tells what shape the building is in).
Who You Gonna Call?
Okay, now that you know probably more than you want to about refinancing, you're ready to shop your mortgage. But, unless your board consists of CPAs, bank presidents, and mortgage brokers, you'll need an expert shopping companion. This might be your building's property manager, a broker, your building's attorney, your existing banker or all of the above.
Perhaps the first and best adviser you should approach is the one you're already working with, that is, your property manager. Your co-op's attorney could be a big help, as well. "You have an agent and an attorney who already have contractual relationships with the board," says NCB's Bonanno. "They have the big picture. And, they have the co-op's interests at heart because they have a long-term relationship with it."
In many instances, a property manager will take on the job of shopping your building's loan. And, because he has immediate access to the documents and information the bank needs, you do away with a lot of back and forth between the bank, the broker, and the manager. "Every time the board needs something for the bank, it comes from the property manager," says Tudor's Shaughnessy. "They need maintenance/rent rolls, they need previous year's financials, they need budgets, if there are unsold shares, the bank will need to know the rent versus the maintenance on the unsold shares. Even if there's a broker involved, I'm going to be the one to follow up with all these requests. So you have to have the property manager on board from the beginning."
Shaughnessy handled the deal for 808 Broadway. "She introduced us to the banks," says Wittman. "We didn't have to use another intermediary or a broker. She did it all for us. It was a painless experience."
Managers usually charge a fee for their services. But the couple of thousand dollars they may charge for their all-inclusive service, compared to the licensed broker's one percent commission (that's $40,000 on a $4 million mortgage) makes for a strong argument in their favor.
Shaughnessy is not a licensed mortgage broker nor does she need to be. Anyone, including you, can shop a mortgage around and make a loan application to a lender. "I go to a couple of banks, I get their best offers, take it back and do the analysis for the board and let them choose. And then once we decide on a going forward process, we send in an application fee," says Shaughnessy. She then pools together all the paperwork for the bank and works in concert with the co-op's attorney to complete the closing.
Despite the fact that a broker may charge you more than a manager to handle your loan, there is a strong argument for using one. The broker is aggressive, knows every financial loophole, and has far more resources than a manager who probably only does business with two or three banks. "Managing agents are very good and bright people but they're not necessarily in touch with everybody in the market as is the broker," says Bruck of Time Equities.
But what about that hefty broker's fee? "If a co-op is taking out a 10-, 15- or 25-year mortgage and they don't they get the benefit of the best rate, that fee is quickly made up," Bruck notes. "The broker, because he has his finger on the pulse of the market, probably can get them a better rate than if they went through their managing agent."
Even though a mortgage broker may charge you more than your property manager to arrange a new loan, there is one strong argument for using one: you can often get a better loan. Whenever potential clients suggest hiring their managing agent or attorney to arrange a new loan, Niland always asks, "Would you ask your dentist to do your heart bypass — just because he charges less? Sure, your dentist knows how to fix things, but you might want a specialist for something this important. The same logic holds true when refinancing your underlying mortgage. You'll get better results from a specialist." Adds Bruck: "Managing agents are good, bright people; but they're not necessarily in touch with everyone in the market."
If you have a good relationship with your existing bank, the best thing to do is go directly to them before you shop the loan around. "I recommend always doing that first just to see what your existing bank will do," says Shaughnessy. "In many cases, today particularly, the banks are so eager to keep you as a customer, that that is where you're going to get the best deal."
HSBC's Grimaldi concurs: "A co-op that has a mortgage with me, unless they have a real relationship with a broker or a managing agent that told them they were going to facilitate the transaction, doesn't have to go to somebody else. If you're inclined and have a board that's savvy enough, you can deal directly with the bank and have pretty good results and not have to pay the [broker's] fee."
First Funding's Niland counters that going back to your current lender may not always result in the best solution. "Of course, it makes sense to contact your existing lender," he admits. "After all, they know your building and probably would like to keep you as a customer. However," Niland continues, "your current lender may not offer the type of loan you need now. Or you may have had a bad experience or want to change lenders for some reason. An experienced broker provides access to the entire universe of lenders, many of whom you'd never find on your own."
There you have it: the who, what, and where of refinancing. Now who you call, what you get, and where you go are up to you. Good luck!