The Deadly Dozen

I just got elected to my building’s board of directors and agreed to serve on the finance committee. Two of the other committee members are pushing to refinance our underlying mortgage as soon as possible to take advantage of lower interest rates. This may, in fact, be a good idea, but I’ve heard horror stories about refinancings gone bad. Can you tell me some things to look out for?

Over the last 20 years or so, I’ve either conducted or participated in a myriad of seminars about underlying mortgages and other cooperative finance topics. In most of these events, I spend some time talking about what I call the “Deadly Dozen” – 12 mistakes that many boards make when refinancing their underlying mortgages. Avoiding these won’t guarantee that you’ll get the best deal, but it will assure that your refinancing won’t be another “horror story.”

At the top of my list of things to avoid is “interest rate myopia” – the obsession that many board members have with getting the absolute lowest interest rate. These misguided folks focus virtually all of their attention on “spreads” (the margin added to an index to set the interest rate for a new loan), and they dedicate enormous energy haggling over one or two “basis points” (100 basis points = 1 percent). The interest rate on your new loan is one of the least important factors in determining whether you got a good deal.

Also high on my list is “payment pinching” – an attempt to keep monthly payments as low as possible by ignoring amortization (the regular repayment of part of the loan principal in each monthly payment). True, “interest-only” loans do have lower monthly payments. However, they also leave the borrower with the same amount of debt at the end of the loan term. Plus, when these borrowers refinance, they almost always have to take out an even bigger loan just to cover the closing costs. Payment pinching pushes most co-ops deeper and deeper into debt, which, eventually, can restrict their ability to refinance on attractive terms.

Two more “don’ts” are “borrowing too much” and “not borrowing enough.” Some boards think that they should borrow as much money as possible just because rates are low. They think that a big, fat reserve fund is a good thing. That’s not necessarily the case. First, the amount of interest you can earn on excess funds always will be less than the amount of interest you’ll pay to borrow them. If you truly think that you’ll need these funds, then this difference in interest rates is cheap “insurance.” However, money in excess of your true needs just adds interest expense to your budget needlessly. Moreover, an excess of money in your reserve fund presents an almost irresistible temptation to spend it – either on operating costs to avoid increasing maintenance or on things that your building really doesn’t need.

At the other extreme are those boards who borrow only enough to solve the most obvious and pressing of their current problems. They fail to assess their building’s likely needs during the next five, ten, fifteen, or more years until their new loan matures. Consequently, at some point during the life of their new loan, most of these boards are confronting an unpleasant choice between a special assessment or refinancing once again (and paying an expensive penalty to do so).

Many attorneys and accountants recommend that their client cooperatives get a credit line as part of any refinancing. While I don’t agree that a credit line is a “must have,” I do recommend that all borrowers get the right to access some form of secondary financing “as of right” (i.e., without lender approval). Failing to have that can leave a building in difficult financial straits down the road.

Some boards think that they should “test the market” every few years to see what’s available. Others think nothing of refinancing every time interest rates drop. The first group eventually gets a reputation in the lending community as a “shopper” who isn’t serious. The second group needlessly squanders thousands of dollars on prepayment penalties. Barring special situations, there is no need to be searching for a new loan until the last six to nine months of your existing loan’s term.

Then there are those boards who wait until it is three or four months before their existing loan matures to even start looking for a new loan. It is possible to close a new loan in that time if everyone is focused and dedicated to the task. However, such a short time frame severely limits the borrower’s ability to compare offers from various lenders, negotiate changes, process an application, deliver a clean title report, give proper notice to the existing lender, and close the new loan before the existing loan matures. If the borrower misses that deadline, hefty fees and higher interest charges can be incurred.

When it comes to refinancing an underlying mortgage, it often seems that everyone either is an amateur financial expert or knows someone who thinks they are one. These well-meaning souls want to “help” get the best deal for their building. So, they proceed to call bankers and mortgage brokers in hopes of uncovering a secret stash of cheap money.

The result is a market polluted by misinformation and unauthorized representation. The solution is to let everyone help, but to restrict contact with the outside world to one qualified individual. And, if the board decides to retain the services of a mortgage broker, a similar rule applies: interview as many as you like, but hire (and authorize) only one.

Virtually every loan requires that the borrower notify the lender of the intention to refinance. This notice must be delivered in a certain way at least 30 – and sometimes as much as 90 – days in advance of the new loan closing. This can get pretty tricky when the existing lender requires irrevocable 90-day notice and the new lender requires commitment acceptance within 30 or 60 days. It gets even worse when a borrower forgets to notify their existing lender and loses a commitment for failure to close on time.

Three more potential problems are hidden title defects, lost loan documents, and unresolved legal and/or environmental situations. The closing is not the venue for uncovering and resolving such issues. Waiting until you have a commitment may even be too late. The best time is before you start talking to lenders.

So, what’s the antidote for the Deadly Dozen? Every one of these problems can be prevented by proper planning and the early involvement of each of your building’s professional advisers. Refinancing your underlying mortgage will be the most important decision that your board will make during its tenure. Their choices will affect not only the monthly maintenance of every shareholder but also the market value of each apartment. A decision of this import should not be undertaken without the full participation of your attorney, accountant, and managing agent from the very start of the process. Avoiding the Deadly Dozen will get you a long way toward a goal of successful refinancing.