When to Take the Refi Plunge

The managing agent was a bit harried and a little miffed. He represented a co-op that had waited until the last possible minute to refinance its underlying mortgage. He had warned board members that interest rates would not remain as low as they were much longer, and therefore they should refinance their mortgage, like now. But the board wanted to avoid the prepayment penalty. Now, with rates about to rise, the manager was rushing to a lawyer’s office to close a just-under-the-wire refinancing. The board’s foot-dragging was going to cost them a sizable amount of money.

That scenario, as related by a manager who lived through it, illustrates just how agonizing the refinancing of an existing mortgage can be for some boards. It usually entails paying a penalty, which some co-ops find hard to stomach. Those pushing for action sooner rather than later, however, worry that putting off refinancing in order to minimize the size of the penalty could mean missing out on lower interest rates.

This back-and-forth is fairly predictable, says Harley Seligman, senior vice president at National Cooperative Bank. “The discussion that usually happens is, the board sits down and someone says, ‘We’re going to pay a penalty of X? Why would we do that?’ And someone else says, ‘I’m worried about paying a higher rate!’”

With rates expected to rise in the coming years, many boards are wrestling with this problem. A more productive approach, say lending experts, is to explore their options. “The idea is not to try to make a perfect decision, or to try to call the exact moment when it’s the perfect time to refinance, but to make the best decision possible with the information available,” says Gregg Winter, president of Winter & Company Commercial Real Estate Finance, which handles refinances.

Why Refi?

The board will first need to be clear on what it is trying to accomplish with a new loan. Are they just looking to save money with a lower interest rate? Many co-ops have already taken advantage of such rates during the past decade, but Seligman says he still gets calls from co-ops looking to get out of loans with rates between 5.5 and 7.5 percent. Rates are currently between 4 and 4.5 percent, higher than a year ago but still at very low levels.

What generally happens is that the board needs to borrow some additional cash to cover a capital improvement project. If the project can’t wait and isn’t just cosmetic, then that needs to be factored into the decision about how much new debt to take on, Winter says, adding: “There is a cost to deferring maintenance – the project could become more expensive.”

It may also simply be time to refi because the existing mortgage is nearing the end of its 10-year term, which means there will be no penalty to pay. In shopping around for its next loan, however, the board should look for the most favorable prepayment penalty terms it can get, Winter advises. “It is possible to get a 10-year fixed-rate loan with a penalty of 3 percent of the remaining loan amount for the first three years, 2 percent in the next three, 1 percent in the next three, and none in the last year,” he says.

Prepayment penalties are essentially insurance for the lender that guarantees a certain return on investment. When used in co-op loans, they are usually structured in one of two ways:The step-down structure specifies a percentage that must be paid on the remaining balance. That percentage gets smaller as the loan gets closer to maturity.

Yield maintenance penalties are more complicated and can be far more costly. The penalty is a calculation of how much the lender is losing as a result of your early pay-off, based on the difference between the loan interest rate and current interest rates. In a highly simplified example, say the interest rate on your current mortgage is 5 percent, and current rates for similar loans are 4 percent. If you want to pay off the loan two years early, the lender figures it will lose 1 percent per year because of the early pay-off, and charges a penalty of 1 percent times the principal balance, multiplied by the number of years left on the loan.

In a rising-rate environment like the current one, the yield maintenance penalty is less of a concern, says Steven W. Birbach, president and chief executive of Vanderbilt Property Management. “The way the yield curve works, if they’re getting more money in the current market, it doesn’t hurt you as much.”

Doing the Math

While identifying your prepayment penalty is a key factor in evaluating any loan option, it is only one of many. Instead of focusing too narrowly on the penalty dollar amount, the board should look at the bottom line: how would the new loan affect the co-op’s debt service? Or more simply, would the monthly payment be any more onerous? And is it accomplishing the stated goal?

“I try and look at the big picture,” says Birbach. “Even if you have a large penalty, if you include it in your new mortgage amount, and it still keeps your debt service relatively stable for the next 10 years, that’s a good thing for shareholders.”The board should also keep in mind that the penalty payment is an interest payment and therefore qualifies as a tax deduction for shareholders.

Another way of thinking about a new loan offer is to look at how much in interest savings the co-op will miss out on if it doesn’t refi and pay the penalty now. That’s the approach used by Steven Geller, managing director at Meridian Capital Group, a commercial real estate finance company. He commonly presents boards trying to make that calculation with detailed comparison charts showing the estimated interest rate savings, and how long it will take to recoup any penalty incurred. Geller notes that he can offer co-ops a 10-year loan on a 30-year amortization, where the first two years are interest-only. “So you can save back a good portion of the penalty that you paid in the first couple of years and replenish your reserve accounts,” he says.

Some co-ops do interest-only loans for the entire 10-year term, but most do not. “We like to see amortization to protect the co-ops,” Seligman says. “When rates go up, you’ve paid down some principal. At the end of 10 years, you’ve probably paid off about 20 percent of the loan amount.” Birbach adds that paying off some of that debt every year means the co-op will be well positioned to go back into the market at the end of 10 years.

For very high-end co-ops, however, the mortgaged amounts are usually small compared to the value of their buildings. Therefore, it doesn’t make sense for those shareholders to pay down more principal, says Mary Frances Shaughnessy, managing director of Tudor Realty Services. “Why pay today so someone 30 years from now doesn’t have a mortgage?” she says.

Shaughnessy also prefers to work with banks making portfolio loans – meaning they aren’t sold off to the secondary market. Because the banks hold on to the loans, they have much more flexibility. “If you go back to the same bank [to refinance],” says Shaughnessy, “you can frequently get them to cut the prepayment penalty in half.”

Either way, with higher rates looming, boards should listen when their property managers suggest it’s time to at least consider refinancing. “We’ve had situations where we begged boards to refinance last year, because we knew rates were rising,” Birbach says. “Over the last 18 months, rates are up a point or more. But for these boards, the loans weren’t coming due, and they didn’t want to pay the penalty. Now, they’ll be paying more.”