Last year, commercial mortgage broker Patrick B. Niland arranged an unusual policy for the underlying mortgage of a cooperative building in Long Beach, Long Island: a straightforward loan that would be paid off, interest and principle, in 30 years.
Such self-liquidating, predictable-thus-safe loans have been an option for boards for years. What made this one unusual was that it was the only one that Niland, president of Rochester-based First Funding of New York, had arranged in several years. And he has to reach all the way back into the early 1990s to remember arranging another one before that.
Brokers and bankers in the tri-state area estimate that 80 to 90 percent of the business they write or arrange these days is for balloon mortgages. They argue that’s exactly as it should be, laying out reason after reason why it makes little to no sense for a building to do otherwise. But that hasn’t stopped some from coming to exactly the opposite conclusion.
All mortgages are made up of principle and interest. A self-amortizing or self-liquidating mortgage is one in which each payment is calculated to pay off interest and eventually principle, so at the end of the term of the loan the outstanding balance has been paid off. The thought of paying off all debt – and reducing maintenance charges significantly – represents a very seductive, common sense lure for some boards and owners.
With a balloon mortgage, that doesn’t happen. Balloon mortgages tend to be for much shorter terms. At some point the loan comes due – usually after 10 or 15 years – and if it has not been fully repaid or amortized, leaving a balance, there’s the “balloon.” The borrower either has to come up with the cash to pay that off, or “they have to go out and get another loan. They refinance that balance and carry it forward,” says Niland.
Within the parameters of a balloon mortgage, there is plenty of room for maneuvering, the main debate being whether to go with interest-only or partially amortizing loans. All interest-only mortgages are balloons but all balloons aren’t interest-only. Instead of paying only interest – and owing the entire principle amount when the loan comes due – borrowers also have the option of paying off, or amortizing, a portion of the principle as well. That still leaves a lump sum due at the end.
Despite the rolling debt that rarely if ever gets paid off, the benefits of balloons are clear, argues Sheldon Gartenstein, senior vice president of the National Cooperative Bank, which in 2005 financed about one-third of all the co-ops seeking funding in the tri-state area. Most importantly, the monthly payment being applied to service the debt is lower, he notes, because interest rates are almost always lower on 10-year loans than on 30-year ones.
Some boards worry that, by taking a shorter-term loan, especially when interest rates are low, they will be exposing themselves to much higher rates when the balloon comes due. But that fear is misplaced, says Steven Geller, director of the Co-op Select Group at Meridian Capital Group, a commercial mortgage broker.
“There are three things that can happen to the rates. Two of them are good. They can go down or stay the same. Nobody can know, and it would be irresponsible for a co-op to incur higher expenses today [by choosing a longer-term loan with a higher rate] because they are worried about [even higher] rates in 2016,” Geller says.
Moreover, inflation works in favor of balloons “In ten years, a dollar today will be worth 80 cents, so you’ll be paying it back in cheaper dollars,” notes Gartenstein. And, although the interest is tax-deductible, the principle isn’t.
Just as important are the unknown factors. If, for some reason, a building needs to break a ten-year loan – and brokers and bankers insisted buildings will often need to do so because of the costs of unforeseen repairs – the prepayment penalties that commercial real estate loans carry will be much less for a ten-year balloon than for a 30-year self-amortizing loan.
Co-ops that choose the long-term self-liquidating loans, Gartenstein says, are generally buildings “where there is less sophistication among the board members, and they are thinking in terms of their own share loans. They want to know that they will have constant debt service and that at the end of the road, after 30 years, [they] will be debt-free.” But, he adds, “that is illusory.”
Unlike personal loans for houses or condominiums, commercial loans carry big prepayment penalties. So, he continues, if the loan needs to be refinanced, “that could eliminate entirely the benefit of knowing that you have constant debt service,” which is the main reason that boards choose the longer loans. Buildings, he argues, almost always need upgrading, whether for plumbing, a roof, or an elevator.
“The number of co-ops that actually see the end of the rainbow is very rare; less than five percent,” Gartenstein says. “For every co-op that should have taken [a self-liquidating loan], I could show you 50 that haven’t made it to the end,” notes Geller, adding that he has seen “cases where co-ops really tie themselves in knots because they have locked themselves into a situation where they can’t refinance,” without paying either an onerous prepayment penalty or an onerous rate on a second mortgage.
And just where are the properties – 10 to 20 percent of the total number of co-op/condo borrowers – that still chose long-term self-liquidating loans? The board of the co-op at 41 Eastern Parkway in Brooklyn is one. Board president Greg Shanklin says he knows the building has taken a less-common route, but notes there were very solid reasons for doing so.
The building, which has about 60 units and was built in 1926, refinanced in 2004, with eight years to go on a balloon mortgage that included a tiny amount of amortization. The building had low maintenance, a solid reserve fund, and the board knew that it needed money for an unknown amount of upcoming repairs, explains Shanklin, a commercial real estate finance lawyer.
Shareholders are a broad cross-section: “Some people bought in at a very low price and are on fixed incomes; some people bought in at a very high price and don’t have fixed incomes.” The internal debate is a common one among co-ops these days: what amenities do we fund – say, a 24-hour doorman or a working laundry room? – given the differing desires of shareholders with different amounts of money.
So, when dealing with the refinancing, he says, his goal was “to try to cap capital costs for the near term.” That way, “if we can make the cost of capital workable for those on a fixed income maybe we can afford some of the capital improvements that some who aren’t on fixed incomes would like.” Some on the board, he adds, were fearful of further encumbering the building every ten years. A balloon, “just becomes a permanent obligation of the co-op that far exceeds the loan amount.”
Since the building had a relatively high interest rate on its existing balloon mortgage, the board found that it could take out a 30-year, fully amortizing loan with a lower fixed rate and keep the debt service payments essentially the same. The co-op borrowed extra cash to cover the prepayment penalty it incurred through refinancing.
As for repairs, Shanklin notes: “We concluded that we had the flexibility within our reserve and our credit line that put us in the position to, in effect, do about a million dollars’ worth of capital improvement.” Some of the costs of the upcoming repair will be covered by assessments; the board is now grappling with how to make them palatable to shareholders who can’t pay upfront.
One Upper West Side building chose to keep its long-term self-liquidating mortgage partially for precisely the reasons that brokers and bankers said they should be rejected: because those who see the benefits are the ones who stick around for a long time. Most often, that is not those who are paying the interest in the early years, given the fact that people tend to move every five to seven years. “Unless there is very little turnover, a self-liquidating loan doesn’t make much sense economically,” says Niland.
Gary Ziprin, the chief financial officer of Midboro Management, approached his company’s client, a 16-unit co-op at 28-30 West 74th Street, about refinancing its self-amortizing mortgage as a balloon mortgage with an interest rate that was a couple of points lower. But the board rejected the idea. With just seven years to go on a 20-year self-amortizing loan, shareholders are now looking forward to seeing their maintenance drop by 25 percent in 2013, “which is huge,” says board treasurer Janet Baldovin. While she only bought into the building three years ago and didn’t pay the early years of interest, she says she was attracted to the co-op because of its low maintenance that was going to be predictable for years to come.
Like Shanklin, Baldovin, a financial planner, has professional experience in the commercial real estate field and says she has “a fairly strong opinion about this.” She believes that with credit easier to obtain, and “aggressive brokers out there that get paid commissions to sell mortgages…debt is getting out of control with co-ops” in the same way it is with personal mortgages and credit cards.
Once a building takes a first step into a balloon mortgage, “it is in a cycle you can’t get out of anymore.” She notes that the prepayment penalties that the brokers worry about are indeed the problem, but for a different reason than the one they suggest. Buildings that continually refinance end up taking on more and more debt to cover those penalties. “You’re not coming out ahead when you are borrowing extra,” she argues.
To cover capital expenses that have come up during the term of the loan, the building has turned to its reserve fund or chosen to assess, she says, adding that if it had taken out extra money in a refinancing, the temptation would have been perhaps to spend money less wisely. “Every expense you have to assess for is so carefully looked at. When you get into a debt cycle, you’re not looking very carefully. This forces you to be more careful.”
Although that building didn’t fit the mold, Niland says that, in his experience, properties that choose the long-term mortgages are often “working-class buildings in Queens and Brooklyn,” populated by school teachers, police officers, government officials, “hard-working middle-America types. They wouldn’t have a balloon mortgage if you paid them. They believe in paying things off.” He calls them “a dying breed.”
As for the one self-liquidating loan that Niland arranged, it came about because of a unique set of circumstances. The building’s new board wasn’t looking for a loan that would pay itself off, but simply wanted to impose some fiscal discipline.
“They had boards in the past that did stupid things and the current board, which is smart and fiscally conservative, wanted to get a loan that would prevent future boards from doing stupid things,” Niland says. “They could have gotten a loan that was less expensive, and had a cheaper payment, but they weren’t willing to expose the building to the risk of future boards.”