When you gain approval for an interest-only commercial real estate loan, you owe a monthly debt service fee. This amount is equivalent to the interest accrual on the principal loan balance. Debt service is a payment made to the lender and includes both principal and interest. Simply stated, principal is the loan amount, and the interest is the fee charged for the privilege of borrowing money.
As an example, a 24-month loan of $11,505, 500 with an interest rate of 5.28 percent amortized over 30 years has a debt service equaling $60.977. This illustrates how the debt service fee is calculated as the interest accrual on the principal loan balance. The monthly payment due for debt service on a non-interest-only loan would include the principal plus interest.¹
If you secure a bridge loan, your debt service fee will be interest-only. However, if you qualify for a Fannie Mae or Freddie Mac agency loan, you may be offered the option of making one or multiple years of interest-only payments. Once you secure an agency loan, you may have difficulty deciding between paying interest-only or principal plus interest each month. Weighing the pros and cons of each option can help you come to a decision.
Advantages of an Interest-Only Commercial Real Estate Loan
For both sponsors and individual investors involved in commercial real estate syndication investing, interest-only loans can offer valuable advantages. Major benefits of these loans to consider include the following:
- Future Income Increases. If you will soon graduate from medical school, law school or another professional degree program, your current property investing budget may be limited. Taking on loan payments in your present situation may seem impossible. Yet when you consider your future earning potential, you can be confident of future financial growth.
By securing an interest-only loan, you can engage in syndicated property investing and make reasonable monthly debt service payments. Looking ahead, making larger monthly payments in future years should not be a problem.
- Rising Property Prices. In a rising commercial real estate market, investors can benefit from interest-only loans as leverage for investing in high-end properties. Obtaining a conventional loan would not enable them to make these investments. With syndication investing, investors can sell their percentages of property investments for profits before the market value drops.
- Good Investing Strategy. If your stock investment portfolio shows significant growth in a profitable financial market, you may not want to sell stocks. Yet you may need cash flow to invest in properties. Perhaps you have available cash to cover these costs, but want to put it toward other investments. In either of these two situations, an interest-only loan may be the best solution.
- Useful Tax Deduction. Any interest payments on property loans of $1 million are tax deductible. For syndication investors with investments in large commercial properties, this financial advantage makes interest-only loans highly desirable. You may be a successful investor in a high tax bracket with a large yearly income. In this case, the property loan interest deduction can lower your income tax payment considerably. In fact, your entire loan payment is tax deductible.
- Equity Payments Allowed on Loan. The majority of interest-only loans allow you to make extra payments for lowering the principal. You can make these additional payments during months when you have the greatest income. This is a good way to lower your future monthly interest payments on your loan while paying down the principal.
Disadvantages of an Interest-Only Commercial Property Loan
There can be some drawbacks to securing an interest-only loan for real estate investing. If your income does not increase at the rate you expected, you may encounter financial difficulty down the road. At the time you need to begin paying down the principal, you may not be able to make these payments. Since 2013, when new federal consumer protection guidelines were instated, lenders have become more careful about granting these loans.
Other disadvantages that you may experience as the borrower in an interest-only loan agreement include the following:
- Lack of Equity Growth. Interest-only commercial real estate loans typically require sizable down payments from borrowers. This ensures lenders of adequate collateral in the event of a default. In general, there is no equity growth for the investor-borrower unless the borrower makes extra or larger payments. If your major focus is on paying down the principal, obtaining an interest-only loan is not a good move.
- Falling Property Values. Before the plummeting property values in 2008, many investors were confident that commercial property was a stable, safe investment. Interest-only loans actually encouraged the rapid upward spike in property prices.
However, when prices dropped drastically as the bubble burst, holders of these loans were charged large interest payments. Since these payments involved properties in which the investors had only small amounts of equity, many investors simply left the property investing arena.
- High-Interest / High-Risk Loans. Lending agents who currently offer interest-only loans on commercial real estate investments need to ensure protection against risk. These loans are less marketable to other financial institutions today than they were previously. As a result, lenders now require larger down payments from property investor-borrowers.
They also charge higher interest rates on interest-only loans than for conventional loans. The greater the risk to the lender, the higher the interest rate charged. Conventional loans are now usually regarded as a better choice with less risk.
- Variable Interest Rates. Interest-only loans are often issued with variable interest rates. The rates change relative to a benchmark funds rate. When there is a rise in the funds rate, your loan interest rate also increases. You may find it advantageous to apply for loans that permit you to lock and unlock the interest rates. With a loan of this type, you can have a better idea of how much your future payments will be.
- Bad Deal Acceptance. Due to the lower debt service within the interest-only period of your loan, you may be tempted to participate in a bad property deal. For example, as either a sponsor or investor in a commercial property syndication investment, you may underwrite standard plus interest debt. Yet the deal may not live up to your expected financial returns.
However, if you underwrite three years of an interest-only investment loan, the deal will align with your projected returns. At your current net income, you know that a conventional principal plus interest loan will not work for you. However, with an interest-only loan, you must be confident that you can increase your net operating income prior to the expiration of the interest-only period.
Estimating Your Monthly Loan Payments
Your monthly loan payments are dependent on your interest rate and on whether your interest rate changes within the repayment time period. The other option is that it may be set at a locked percentage of the loan balance. Remember that your equity balance will not adjust during the loan period that carries no interest. Consequently, you will not have any lower monthly payments due unless your interest rate is lowered.
If you obtain a conventional loan as a syndication property sponsor or investor, your monthly payment amount will not vary. However, as your interest payments slowly decrease, the principal increases as you pay down the loan. With an interest-only loan, your monthly payment can vary since since it is based on the interest rate and on the balance.
In addition, if your loan interest rate adjusts, or if you make extra or higher principal payments, your monthly payment may change. Remember, as well, that after the end of the interest-only period, your minimum monthly payment amount may spike upward significantly.
Managing Interest-Only Loans as a Commercial Property Syndication Investor
The great advantage of commercial real estate syndication investments is that each investor funds a fraction of a large investment. For this reason, you will most likely need only a moderate size loan to cover your portion of a total investment.
This type of property investing enables you to choose investment opportunities within your financial means and investing budget. You will never need to try to obtain a conventional loan or an interest-only loan that is beyond your reach for making timely repayments.
Weighing the Pros and Cons of Interest-Only Commercial Property Loans
Some commercial real estate investors may have mixed feelings about obtaining interest-only loans to finance investments. Especially if you are new to syndication property investing, you may be weighing the pros and cons. To most investors, these loans look attractive due to the interest-only payment period. Yet as a new investor, you may have definite concerns about your ability to pay down the principal later on.
To more experienced syndication investors, however, these loans are quite helpful for funding profitable investments with a moderate net income. These investors have planned ahead and are confident that they will have significantly higher income levels in future years.
They have no doubts about their ability to pay down the principal on these loans on future dates. They appreciate the value of being able to make investments with the aid of interest-only loans for the purpose of gaining high returns later on.