This question came from Kiho Kim in Anaheim, California and, surprisingly, doesn’t have a straightforward answer. When someone asks me that question, I know that they’re probably focused on one thing: The loan with the lowest interest rate. Unfortunately, in commercial real estate, this approach can end up costing you a lot of money.
When you get involved in commercial real estate, you become involved in a more sophisticated method of investing your money. Commercial real estate and commercial real estate loans have a lot of “moving parts” and the approach that commercial lenders take is far different from those in residential lending. When considering financing on a piece of investment property, you have to approach the process with ”commercial mortgage planning” in mind.
What is commercial mortgage planning? It’s a process in which all aspects of the loan are considered in the context of the commercial real estate investor’s current portfolio, future portfolio goals, style of investment, and cash flow needs. Let’s see how this works in a practical example and then use that example to further answer the original question in the first paragraph.
Which is the best loan? A 3/1 ARM with a declining 3 year pre-payment penalty of 3%-2%-1%, a rate of 6.75%, a full amortization of 30 years, and a margin of 2.50% over 6 Month LIBOR, or a 10 year fixed rate loan due in 10 years, with a 30 year amortization, at a rate of 5.9%, with a Yield Maintenance prepayment penalty until 9.75 years have passed?
On the face of it, the 30 due in 10 is almost a full percentage point less in rate! No brainer, right? Let’s fill in a few more details and see if this analysis stands.
The investor contemplating the loan is an active real estate investor who purchases properties that have vacancies or month to month tenants that are slightly run down and in need of upgrades. He holds properties until re-tenanted, renovated, and then sells them to generate cash for new purchases in a 1031 Exchange to preserve his buying power.
In light of this information, the 30 due in 10 would be a terrible loan. It’s likely that such an investor would be ready to sell the property in the 3rd year to take advantage of the 1031 Exchange holding period and provide a stabilized leasing history to a new buyer. He’d only face a 1% pre-payment penalty using the 3/1 ARM, something he could easily factor into his “costs.” The fixed rate loan with its Yield Maintenance pre-payment penalty could literally cost him hundreds of thousands of dollars, depending upon market conditions, when he goes to sell the property. In fact, it would likely contain a “lock out” clause completely preventing a payoff for up to 4 years. That loan would have to be assumed by the new buyer and the difference made up in cash, limiting the potential pool of buyers for that property.
So how does this example answer our question: “What is the best commercial mortgage?” This way: “The best commercial mortgage is the one that best fits the commercial investor’s short and long term goals, risk tolerance, investment style and the investment at hand.” And as a side note, be sure to work with someone experienced not only in commercial loan brokerage, but who will take the time to consider all of the factors that could affect the current and future transactions.
