Loan Talk

Borrowing long-term: good or bad?

At the annual shareholder meeting for our cooperative, the board president announced that the board had decided to replace the building’s underlying mortgage. He then proudly described all of the benefits of the proposed new loan, including the savings over the next ten years from a lower monthly payment. What he didn’t reveal, until a savvy shareholder pressed him, was how much it would cost to get this new loan and how much money we would still owe at the end of ten years. I then asked why we weren’t requesting a 30-year loan so we could pay off the whole amount and not incur all of the closing costs each time we refinanced. The president told me that such loans don’t exist anymore. Is that true?

It is true for your building and most other cooperatives seeking loans of less than $1 million. For cooperatives that need more than $1 million, though, 30-year self-liquidating loans are still available. However, I don’t recommend such a long-term loan for any of my clients. Why?

First, I don’t believe that anyone can predict, with any degree of certainty, what will happen over the next 30 years. Therefore, why would anyone want to lock his building into a capital structure for such a long period when changes in the building’s financial needs are virtually guaranteed? Remember, most co-op buildings in the greater New York City area are old enough to require major repairs and/or preventive maintenance every seven to twelve years. If a building has a long-term underlying mortgage, where will the funding for those repairs come from?

Increased maintenance? Possibly, but substantial maintenance increases are quite unpopular with shareholders…and they are a very slow way to raise money. Assessments are only slightly better as a funding vehicle because they, too, can be politically unpopular, less advantageous from an income tax standpoint, and take a long time to collect. Credit lines can provide emergency funding, but I don’t know of any lender that will commit to a credit line for more than ten years, let alone thirty. Plus, credit lines are variable-rate debt…a poor way to fund capital improvements and a potential budget-buster in times of rising interest rates.

What about second mortgages? Seconds are a good solution…if you can find a lender to give you one (hint: they are few and far between).

The second reason I don’t recommend 30-year loans is cost. In today’s financial market, the interest rate on a 30-year self-liquidating loan is almost two percent higher than the rate on a more typical co-op underlying mortgage, which is a 10-year loan with 30-year amortization. For each $1 million of new debt, this rate differential represents almost $130,000 in extra debt service over each 10-year period. That’s an awful lot of money that could be put to much better use in the typical co-op building’s budget.

Despite the higher cost, some co-op residents argue that a 30-year self-liquidating loan will allow them to “build equity” and that, eventually, their apartment value will “skyrocket” because their building will be debt-free. Whether the value of individual apartments in a building with a long-term loan will increase dramatically over time will depend much more on the apartment itself, the physical and financial condition of the cooperative as a whole, and the state of the real estate and financial markets whenever the apartment owner decides to sell than on the type of underlying mortgage on the building.

Further, since the mid-point in a 30-year self-liquidating loan occurs during the 21st year, shareholders must remain in the building for a long time to accumulate any appreciable equity due to loan amortization. If they don’t, most of that equity build-up will accrue to the people who purchase apartments from the folks to whom current shareholders sell.

Consequently, this argument falls flat for the typical New York area co-op resident who moves, on average, every seven years.

The third reason I discourage long-term loans is the prevailing wisdom of cooperators themselves. In more than 20 years of helping boards arrange new financing, I have closed just two 30-year loans…and each of those was caused by very special circumstances. All of the other boards felt that a long-term loan was not in the best financial interest of their shareholders. That’s a lot of smart people who independently came to the same conclusion.

The fourth reason is experience. Every year, I work with several boards who desperately need funding for emergency repairs or necessary capital improvements but are stymied by the terms of their existing long-term underlying mortgage. In many cases, their only option is a very onerous prepayment penalty and an expensive premature refinancing…most of which could have been avoided had an earlier board made better financing decisions.

So, what would I recommend for your building? Actually, something very close to what your board president described at your recent annual meeting. Ten-year loans are, by far, the most common form of underlying mortgage for New York area co-op buildings. They are readily available from a wide range of lenders, so the pricing is very competitive. For example, interest rates on new 10-year loans run from the mid-five percent range for amounts under $500,000 to the low-four percent range for loans over $5 million. Over the last several months, it seems like every new loan that I’ve closed has set a new record low interest rate. In other words, it is a very good time to refinance underlying mortgages.

It appears that your board may have made a wise decision. I hope that, before making that decision, they consulted all of your cooperative’s professional advisors. That is a question I would ask your president because refinancing an underlying mortgage, even at today’s record-low rates, is a very serious undertaking. It will affect not only the monthly maintenance of every shareholder but also the market value of every apartment. Therefore, it deserves thorough analysis and careful evaluation before your president signs on the dotted line.