The Difference is in the Details

The Difference Is in the Details

Q

My cousin and I live in virtually identical buildings about two blocks apart on the same street. My building refinanced its underlying mortgage last month at what we all thought was a very good rate. My cousin’s building just refinanced its mortgage for almost twice the amount we borrowed, yet they got a much better rate. How can that be? I thought banks charged higher rates for bigger loans because they are riskier.

A

If, as you say, both buildings are “virtually identical,” one could argue that your co-op, the one with lower debt, is a safer credit risk. However, before deciding to make a loan and what interest rate to charge, lenders consider many factors. I usually group those factors into three profiles: financial, physical, and ownership.

The overall debt burden of a co-op is just one aspect of its financial profile. There are other, perhaps more significant, factors. For example, a history of balanced budgets would show prudent fiscal planning, while frequent operating losses could signal poor financial discipline. Minimal shareholder arrears would indicate strong collection policies, but large and/or persistent delinquencies would raise serious concerns. The size of the reserve fund could suggest how well a building might handle an unexpected expense, and the lack of one could indicate a hand-to-mouth operating style. A solid credit rating shows that the co-op regularly pays its bills in a timely manner. Co-ops with higher debt loads but better scores on all of these other parameters would be viewed more favorably by most lenders than co-ops with lower debt but a weaker financial picture.

The physical profile of the building is equally important in loan underwriting. Are all of the co-op’s major building systems – the roof, façades, windows, heating plant, plumbing, and electric service – new or in good repair? If part of the new loan will be used to fund capital improvements, has the co-op board consulted an engineer to evaluate the plan, materials, contractor, and estimated cost? Is there an underground fuel storage tank on the property and, if so, has it been pressure-tested and certified as leak-free? Does the building have a good selection of apartment sizes and floor plans? Does the building offer other amenities like a laundry, garage, health club, or storage? Buildings that have been well maintained are more attractive to lenders as collateral for a new loan.

The ownership profile of a co-op often determines what type of loan the building will get, its interest rate, and, in some cases, whether it can get a loan at all. One of the first questions that most loan officers will ask a prospective borrower is, “What percentage of your building is sold?” Buildings with significant sponsor ownership (i.e., more than 10 percent) undergo another level of scrutiny focused on sponsor identity, monthly rent-versus-maintenance cash flow, and sponsor financial condition.

After the “percent sold” question comes the “percent owner-occupied” question. In other words, of the non-sponsor “sold” apartments, how many are occupied by their owners as their principal residence? Buildings that place no limits on investor-owned rental units and former resident sublets sometimes find it difficult to secure financing on attractive terms. Capping these non-owner-occupied units at five percent or less can alleviate such problems.

Also, most lenders like to see some shareholder turnover. It’s not that low turnover is bad (although that sometimes can be a problem). It’s just that multiple apartment resales give lenders some idea of current market values and likely future values. For example, over the last several years, have sales prices been rising, falling, or remaining relatively stable? Buildings without turnover need not despair, though, because almost every lender will order a professional appraisal of the property as part of the loan process.

Without knowing more about your cousin’s co-op, I can’t say for sure whether any of the above factors contributed to their lower interest rate. Each loan officer evaluates potential borrowers in his or her own way, giving more or less weight to individual parameters. And each lender has a loan appetite that’s slightly different from that of its competitors. While these differences tend to be subtle, they can, at times, result in varied loan terms.

Another factor that probably played a role in your cousin’s building getting a lower interest rate is volatility in the financial markets. Today, most co-op underlying mortgage loans are priced using a formula based on the 10-year U.S. Treasury rate. This interest rate, which reflects the return paid by the U.S. government to borrow money from investors, has become a benchmark for all sorts of financial instruments. When making a new loan, lenders set the interest rate by adding a “spread,” or margin, to the current 10-year treasury rate. What many people don’t realize is that both the 10-year treasury rate and the spread change from minute to minute in response to trading in the financial markets. So, even if your building and your cousin’s co-op were identical, and even if both loans were priced on the same day, each could receive a different interest rate.

Finally, as you noted, loan size does matter. However, it matters in a way that is different from the way you thought it did. Most investors in the mortgage market are like Sam’s or Costco. They buy in bulk and pass those savings on to their customers. That’s why bigger loans – those over $5 or $10 million – usually receive lower (and, sometimes, depending on the quality of the borrower, much lower) interest rates than smaller loans. Since you said that your cousin’s building borrowed almost twice what your building did, I suspect that size played a role in the lower rate as well.

I know how relatives sometimes can make life miserable with their gloating over some lucky circumstance. However, you can take comfort in the fact that current rates are so low that both buildings surely got a great rate. That and the fact that, with a much larger underlying mortgage, your cousin’s monthly maintenance is likely higher than yours.