Refinancing: Take a Sharp Look

Examine closely. If you’re looking to refinance your underlying mortgage to get money for capital repairs, you need to examine your documents to see where you stand on prepayment penalties. There are two kinds. One is a sliding scale, where the penalty is  based on the balance you owe. For example, in the first two years of a 10-year loan, you might pay 5%, then go down to 4% in next two years, 3% after that and so on until the prepayment penalty is zero.

Those are fixed numbers and easy for boards to calculate. But the other kind of prepayment penalty—yield maintenance—is more complicated. Banks look at the current interest rate, the rate of your existing mortgage and how many years you have left, and then they use a formula based on how much they might be losing to come up with the prepayment penalty. If current interest rates are higher than that of your existing mortgage, the bank loses less money and the penalty could be as little as 1%. If current rates are lower, the penalty could be very onerous.

Financial backstop. A line of credit can be helpful because you don’t have to start paying it back until you use the money. The problem is that lines of credit have a floating interest rate, not a fixed one. In today’s market, that means you could be paying as much as 8% interest as opposed to a mortgage where you would be paying 5% or 6%. And between the bank attorneys, co-op attorneys and bank commitment fees, you’re looking at spending $20,000 to $30,000 just to get that line of credit. So boards have to really analyze the numbers to figure out the best way for them to go.

Eye on the rates. We manage a building in Manhattan that refinanced its mortgage from 6% down to 4% several years ago. The board was very happy because it was able to take out an extra $500,000 without increasing its monthly payments. The mortgage had a sliding scale prepayment penalty, so when interest rates kept dropping we recommended refinancing again even though it was only three years in, because we were able to get a new rate at 2.95%. Now, with interest rates going up, the building is in a very good position.

The best scenario. When you're doing a mortgage refinance, look ahead at your 5- or 10-year plan for the work you’re looking to do, and see if you can borrow additional funds based on current rates and still be close to what you’re now paying. That’s the best scenario, since you won’t have to increase maintenance. 

I would strongly suggest getting a line of credit as a rainy-day fund because doing that now will cost a lot less than doing it after you’ve refinanced. And if you don't use it, the worst-case scenario is you pay what’s usually about 0.25% of the total amount on an annual basis. 

We have a property that needs to do an elevator modernization and is having difficulties refinancing because of the high sponsor concentration in the building. But the building had that line of credit, so it can do the project and do an assessment over a longer period of time, which is going to be a lot more palatable to shareholders.