Present Value, Future Profits

An accounting technique called present value analysis can uncover profits in refinancing an underlying mortgage, often winning over skeptics on co-op and condo boards that thought it would not be cost-effective. Just ask board members at the 749-unit Celtic Park cooperative in Woodside, Queens. They thought refinancing was unaffordable, until they did the numbers with a knowledgeable CPA.

Most underlying mortgages have a prepayment penalty, which means that if you refinance before the maturity date of the loan, a premium is due to the lender. The amount of the premium depends on the interest rate of the mortgage and the interest rate at the time of refinancing. That's the spread that the bank has to cover, because it has, in turn, committed a certain rate return to borrowers and investors. In addition to covering that spread, the mortgage agreement may provide for an outright additional penalty that adds more to the cost of refinancing.

But it's not just the face value of the difference between the two mortgages (also adding in any additional penalty the bank may charge) which a board must consider. It's also the cost of money over time - the key to present value analysis. The basic principle is that a dollar that is paid or received today is worth more than a dollar that is paid or received at any future time. That's so because, over time, money can earn interest or can be used to pay back interest and principal on a loan.

When money must be paid out over time, there's a cash outflow that can be calculated to have a present value in current dollars, if you know the interest rate payable as time moves forward. It's also necessary to forecast how interest rates may change, if you want to get a good picture of how a future refinancing may compare to a refinancing done today.

Carole Newman, a CPA with 20 years' experience in the co-op and condo marketplace, found a way for Celtic Park to refinance - even while paying a steep prepayment penalty - by doing just that. "The board needed money for capital improvements, but they didn't want to have to go to the shareholders for an assessment," she says. "However, they also believed that the prepayment penalty on their existing mortgage - which was estimated to be $1.1 million - prohibited them from refinancing.

"I suggested that we do a present value analysis," Newman explains. "The present value analysis takes the current mortgage and compares it to the new mortgage by taking the present value of the annual payments over the lives of the two mortgages. When you do that, you have to add in the cost of the prepayment penalty as a cash outflow, and you have to add in your closing costs to refinance as a cash outflow. When you get the present value of those two situations, you can then determine whether or not the refinancing is worthwhile."

For Celtic Park, Newman not only compared the cost of a refinanced mortgage with the same lender to the cost of the current mortgage, she also compared it to three different offers from three different lenders. The annual debt service on the old mortgage was $828,000, and the debt service on the proposed refinanced mortgage was $665,000. The old mortgage would come due in three years, Newman recalls, "so we had to make an assumption about where interest rates might be in three years."

Figuring that the co-op would have to pay seven percent on a refinancing loan three years down the line, Newman calculated a present value of $9,115,000 to let the current mortgage mature and then obtain a new one. The forecast looked ahead ten years, and included closing costs for each loan. Refinancing the loan today, Newman found, would cost between $8,250,000 and $8,300,000, including prepayment penalties.

"Not only did the present value analysis show that the refinancing would produce a lower cost going forward, but annual debt service alone would decrease significantly," she says. "So, it worked. The board refinanced and increased their mortgage indebtedness from $7.3 million to $11.5 million (which was increased from the original proposed amount of $10 million), thereby obtaining the funds to satisfy the prepayment penalty, pay the closings costs on the new loan, and have money left over for capital improvements."

With the help of the CPA and her firm, Newman, Newman & Kaufman of Syosset, the board prepared a proposed capital budget plan, determined what it needed in the way of capital improvements, and worked backwards from there.

The tricky part, Newman says, is figuring out not only where interest rates can be expected to be in the future, but also determining just how banks calculate the prepayment penalties they charge, which varies from bank to bank.

Richard Garber, first senior vice president of Valley National Bank, a major co-op lender, says that he looks at the interest rates for U.S. Treasury bills - a standard benchmark - and then adds "points" on top of that rate to determine the interest rate the bank offers.

"If we make an underlying co-op loan," Garber says, "we have to be compensated for the additional risk if the loan is prepaid. It's really a function of the market and our own internal comfort level. Right now, some institutional lenders may be doing refinancings at less than 100 points over the Treasury bill benchmark, but we can't participate in that market because the margin is too thin. We're a portfolio lender and we hold the loans."

Newman cautions that there are variations from bank to bank in how they calculate prepayment penalties. "While every mortgage document says the prepayment amount is a 'yield to maintenance' formula - meaning that the bank has to get a certain yield to maintain the return on their investment - banks have different ways of computing this." A board should ask its mortgage lender to calculate the prepayment penalty for its building instead of relying on its own computations, Newman says.

Newman adds that present value analysis will generally show that a co-op loan that is self-amortizing at a high rate and has a prepayment penalty won't pass the cost-effectiveness test. "I have two buildings which asked me to do a present value analysis - both had relatively short-term (15-year) self-amortizing loans - and it didn't work for them." She cautions that every board must weigh the costs of passing along debt to future shareholders against holding monthly payments down right now.

A board must also be prepared to act quickly on the advice of its CPA. While the board is taking the time to digest various alternatives, interest rates are continuing to change and, depending on the stability of the market, "everything could change at a moment's notice. We were doing the calculations at Celtic Park last summer," Newman says, "and rates were changing. You can't do the present value analysis today, and rely on it three months later."

One way to approximate a prepayment penalty in a yield-to-maintenance formula, Newman says, is to use a website at http://www.columnfinancial.com/MyColumn/tools/calculators.aspx?pn=prepayment. It will allow you to calculate the minimum prepayment penalty set by your bank, and the yield maintenance penalty for a given loan.

While interest rates remain low, making refinancing possible, present value analysis is a tool of great importance. "I really enjoy projects like this," Newman says. "This is really helping boards make the right financial decision about a very important issue. The most difficult time boards have is when they're locked out of refinancing completely, and that's a real problem. It may be worthwhile for a board to pay an extra half or quarter point not to have a long-term lockout that prohibits refinancing under any terms. Build in flexibility to your loan, even if it costs a little more."