Answers to the Most Frequent Questions about Co-op and Condo Financing
A: Having served as the president of my co-op’s board of directors, I can understand your frustration. Refinancing an underlying mortgage is the most important decision that a board will make during its tenure. It will impact not only the monthly maintenance of every shareholder but also the market value of every apartment. Five days hardly seems enough to review and vote on such an important issue, especially after waiting so long to get it.
On the other hand, having been a banker for several years, I can understand things from the lender’s viewpoint as well. By the time a lender has issued a commitment letter, they have done quite a bit of work. They don’t want that effort to go down the drain because the borrower takes the commitment and shops it around town with other lenders. Instead, they assume that you’ve already done your comparison shopping and are ready to move forward. In the lender’s mind, five days is more than enough time for an organized and serious borrower to review, sign, and return a commitment.
So, who’s right? Both are.
One of the very first articles that I wrote for this publication: “Six Steps to Success” (August 1991) listed six actions that every co-op board should take before looking for a new underlying mortgage. The sixth step was “Respond Promptly.” In other words, every board should organize itself and its professional advisors (managing agent, attorney, and accountant) to be able to respond very quickly to all lender requests.
Why? Because loan officers always have multiple loan requests on their desks. They will work on whichever ones have submitted all of the required information. If your application package is poorly organized, incomplete, or the loan officer has questions that go unanswered for more than a day or so, it might get put aside. Lenders are very busy, so the easier you can make their job, the faster you’ll get approved. The fact that your loan took more than three months to get approved tells me that (a) you have a problem or two that required more detailed analysis or (b) you did not submit a complete application package, and/or (c) you did not respond promptly to the lender’s questions. Loan officers are paid to make loans so, the faster you give them everything they need, the faster you’ll get a commitment.
Once a commitment is issued, the loan officer is anxious to turn the file over to the lender’s attorney and move toward a closing. In their mind, the business terms have been discussed and agreed upon, i.e., the deal is done. Therefore, delays in accepting the commitment, or protracted negotiations over the terms of the commitment, cause the loan officer to wonder whether they should have issued it in the first place. That is not a favorable situation.
Moreover, in today’s highly volatile interest rate environment, moving quickly can save you literally thousands of dollars. Most lenders give borrowers a fairly wide window within which to lock the interest rate on their new loan. However, lenders rarely allow borrowers to lock their interest rate until they have accepted their commitment and put up a rate lock deposit. Nothing is more frustrating than not being able to lock your interest rate as the market moves up. Therefore, the sooner that you can be in a position to lock the rate and take advantage of market drops, the better off you’ll be. And to do that, you almost always have to have returned an accepted commitment.
But, you say your attorney is away on vacation, and two board members are out of town on business, so there is absolutely no way that you can return the commitment before they get back. Fine. Ask for an extension. Almost any lender will extend the deadline to accept and return your commitment. However, the length of that extension, as well as the willingness of the lender to continue to hold the interest rate spread, often will depend on your level of cooperation up until that point. This is when your organization and prompt responses throughout the loan approval process can pay big dividends.
Lastly, never accept a commitment without talking to your attorney. Their valuable input is essential and can save you both money and headaches down the road. That said, you should make sure that your attorney has experience closing underlying mortgage loans. This is a somewhat specialized form of loan that not all attorneys thoroughly understand. That sometimes results in the attorney requesting changes to the commitment that the lender will not accept. If you or your attorney persist in such requests, your loan could get repriced or, worse, rejected. So, you might want to consider retaining one of the many attorneys who are very familiar with underlying mortgages, know most of the lenders, and can review your commitment and close your new loan quickly. They might cost a little more, but you’ll make that back tenfold in a better deal and a faster closing.
A: Refinancing an underlying mortgage loan is the most important decision that a board can make during its tenure. It affects not only the monthly maintenance, but also the market value of every shareholder’s apartment. It is a decision that should be based on thorough and careful analysis, not impulse.
More than twenty years ago, I wrote an article for this magazine about refinancing titled “Six Steps to Success.” Those six steps are as valid today as they were back then.
More than twenty years ago, I wrote an article for this magazine about refinancing titled “Six Steps to Success.” Those six steps are as valid today as they were back then.
Step #1. Know your facts.
Loan officers quickly lose interest in buildings whose representatives don’t have important information at their fingertips. Before calling any banks, assemble and review all of your co-op’s records. Then put together several sets of the following:
- A basic fact sheet, containing the co-op’s address, block and lot numbers, lot dimensions, number of units, number of floors, number and type of elevators, type of heating system and fuel, and conversion date.
- The offering plan and all amendments.
- An up-to-date maintenance roll showing each apartment, the shareholder’s name, the current monthly maintenance charge, and the payment status.
- A list of sponsor, investor, and sublet apartments showing the rents collected from each tenant. A comparison of rents collected to maintenance charges is particularly important.
- Financial statements from the most recent three years.
- A list of all apartment resales (with prices and sale date) during the most recent three years.
- Information regarding your existing debt (current balance, lender, monthly payment, interest rate, due date, and prepayment terms).
- Copies of recent bank statements, including your reserve fund.
Step #2. Know what you want.
No board should begin shopping for a new underlying mortgage loan until they have spoken with all of their professional advisors: their attorney, their accountant, and their managing agent. Your attorney will tell you whether your existing loan allows you to refinance at this time, and they will ensure that your co-op’s interests are protected throughout the process. Your accountant can help you develop a financial plan and a post-refinancing budget. Your managing agent knows your building’s physical condition and can advise you concerning the potential cost of future repairs. All of this information is essential to determining the right amount to borrow and how your new loan should be structured.
Cooperative underlying mortgage loans come in a variety of forms and terms. The most common format is a 10-year loan with a fixed rate of interest and amortization (principal repayment) on a 30-year schedule. This type of loan has a balance at the end of ten years (sometimes called a “balloon”) that must be paid or refinanced. A popular variant of this loan format is a 10-year loan with no amortization (sometimes referred to as “interest only”).
In addition to these two formats, there are 5-year loans with renewal options, and fixed-rate loans for 15, 20, 25, or 30 years. There also are second mortgage loans and credit lines that can provide additional funding for capital improvements and other needs in future years. Credit lines can be revolving (borrow and repay at will) or not, and secured (by a mortgage) or not.
Step #3. Learn the market.
The financial markets are complex and constantly changing. Even those who work in them every day differ about the cause of current conditions and direction of future trends. However, it is possible to develop a general sense of whether interest rates are rising, falling, or staying the same by reading the financial press, listening to business programs on the radio and television, and searching the internet. You might invite your accountant to facilitate a board discussion of these and related issues.
Since the cooperative form of housing ownership is heavily concentrated in the greater New York metropolitan area, virtually all of the lenders are located there as well. However, not every lender in this region makes underlying mortgage loans. Further, not every cooperative lender makes every type or size of loan. Therefore, you might want to consider the services of a reputable mortgage broker to help you find the right lender for your new loan.
Most (though not all) lenders set the interest rate for underlying mortgage loans according to a formula that includes an “index” and a “spread.” The most common index is the 10-year U.S. Treasury rate, which can be found in any daily financial publication or on any financial web site. The spread is most often expressed in “basis points,” where 100 basis points equals 1.00%.
Step #4. Understand what a loan officer does.
Loan officers are busy, just like the rest of us. They appreciate a courteous manner, straightforward questions, honest answers, and all of the facts. They will be happy to give you a loan if (a) it makes financial sense and (b) it meets their bank’s criteria. Your loan may be too big for one lender and too small for another. You may want a format that a particular lender does not offer. Or you could be rejected because your building has too few units, too many sponsor units, no elevator, poor physical condition, environmental contamination, or insufficient history as a cooperative. Lastly, loan officers generally do not approve loans; they recommend them to their loan committee. The loan committee makes the final decision, sometimes changing the terms initially offered by the loan officer.
Step #5. Select a “point” person for your loan transaction.
Given the importance of refinancing your underlying mortgage loan, you may want to involve several board members (or experienced shareholders) in the effort. However, channel all communications with the outside world through one person. This is the only way to guarantee accurate transmission of information about your cooperative and consistent interpretation of lender feedback.
Step #6. Be very responsive.
Whenever a loan officer requests additional information, a decision, or some action, don’t delay. Make sure that your point person has enough authority to make basic decisions, or establish a method to obtain same-day responses for such issues. Requiring full-board input on every question is a sure way to sideline your loan application.
Don’t forget that the financial markets can change faster than the weather. If they move enough in the wrong direction, your favorable loan terms can evaporate overnight. This advice applies even after you’ve received your commitment letter. So, stay focused until your new loan closes. Then, it’s a champagne toast for everyone!
A: Lenders consider a host of factors when “underwriting” a new underlying mortgage loan. These factors include property location, new loan amount per unit, percent sold, percent owner-occupied, recent apartment resales, overall co-op financial performance, and general building condition. The best way for a board to improve its building’s standing among lenders is to be thoroughly prepared for the refinancing process. This includes having all of the relevant facts about your co-op at your fingertips, knowing how much you want to borrow and why, being familiar with the mortgage market, responding promptly to lender questions, and assembling a team of competent professional advisors (managing agent, attorney, accountant, engineer, and mortgage broker) to guide the refinancing effort.
A: Miracles are like winning lottery tickets: They happen, but not very often. They also tend to perpetuate the underlying problem of not planning ahead. But that’s a topic for another column.
Right now, you have two issues: which repairs to make and in what order and, then, how to pay for them. First, I would go back to the engineer and ask them to prioritize all of the work. My guess is that, given the time of year, and the relative impact of a failure in each system, the order will be plumbing, then electrical upgrade, then enough repairs to tide your boiler over until next summer, then the rest of the work. Your managing agent can help you develop a detailed budget, lay out a realistic schedule, and select qualified contractors to assure that you get on-time completion of high quality work, at reasonable cost, with minimum disruption. However, no matter which way you cut it, you’ll be looking at some big numbers. But choosing the right funding plan can make them more palatable.
There are several ways to pay for this work. You could raise maintenance by an amount sufficient to raise the needed money over some period of time. The disadvantage to this method is that it takes a relatively long time to raise large sums, and it forces you to delay the work until you’ve collected almost all of the money needed for each project. Given the urgency of some of your repairs, this method doesn’t meet your needs. However, it may be something to implement now as a way to start raising funds for future projects.
You also could levy an assessment to pay for each project. Assessments can raise large sums fairly quickly, but they tend to be rather burdensome to most shareholders. This would probably be the case in your building because your assessments will either be very large or continue for an extended period of time to raise the amount of money necessary to complete all of your work. Additionally, assessments have no short-term tax benefit since they get added to each shareholder’s basis instead of being deductible in the year paid.
Lastly, you could borrow the necessary funds. The most obvious source is your existing lender. Since they hold your building as collateral for their loan, they have a vested interest in preserving that collateral. So, you might ask them for a second mortgage and/or a credit line to fund some or all of your repairs. However, be prepared for some resistance because, in today’s economic environment, not all lenders are comfortable increasing their investment in real estate. If your existing lender won’t give you secondary financing, you can ask them to waive or reduce their prepayment penalty and give you a new underlying mortgage big enough to repay the existing loan and fund your needed repairs. Many lenders are more amenable to new first mortgage financing because they can sell those loans to Fannie Mae or Freddie Mac and recoup most of their capital.
If your existing lender won’t give you a second mortgage, a credit line, or a new underlying mortgage, you then can ask them for permission to get subordinate financing from some other lender. Your lender does not have to grant you this permission, but most lenders will allow some subordinate financing if it is used solely for needed capital improvements. That said, finding another lender that is willing to provide secondary financing (either a second mortgage or a credit line) can be difficult in today’s market.
Which brings me back to your existing lender and that onerous prepayment penalty. Sometimes the better, albeit initially more costly, solution involves paying a prepayment penalty in order to be able to properly structure financing that supports the long-term financial health of the cooperative. As difficult and painful as paying the penalty may be, try to view it as the price of correcting the fiscal mistakes of previous boards. Still, it will take courage to pay that price now. However, if you don’t pay it now, it only will grow bigger over time. And, sooner or later, that price must be paid.
Once you are free of your existing loan, you have myriad ways to fund your needs. One option is a new fixed-rate underlying mortgage large enough to fund all of the work recommended by your engineer. This has the advantage of tying up all of the money you need at today’s relatively low interest rates. However, since your capital improvement program likely will stretch over several years, you will be paying now for money that you won’t spend right away. Also, even at today’s rates, a loan that large probably will be too expensive for your shareholders.
Another alternative would be a loan large enough to complete the three critical projects (plumbing, electrical, and boiler) over the next three years, with an option to roll that loan into a larger loan to tackle the next three projects over the following three years. This structure would have a low interest rate and would guarantee funding for all improvements, but it would not burden shareholders with the entire bill up front. While this format does expose the cooperative to some interest rate risk in three years, that risk would be a small price to pay for the flexibility of this structure.
Yet a third option would be a construction-type loan at a floating interest rate that converts to a fixed-rate mortgage as soon as all of the work is completed. This structure matches funding to spending and minimizes interest costs. However, it also maximizes exposure to interest rate risk. That could cause budgetary headaches should interest rates start to increase dramatically before all of the work were completed and refinanced out into the fixed-rate loan.
You have a very difficult situation to resolve. Unfortunately, the solution will be neither easy nor painless. But with thorough analysis, determination, and sound advice from all of the cooperative’s professional advisers (your accountant, attorney, managing agent, and maybe a good mortgage broker), you will find your “miracle.”
A: I receive questions like these several times each year, as well as similar ones about accountants and managing agents. It always surprises me that board members, who have a fiduciary responsibility to protect the interests of their fellow shareholders, would undertake the most important transaction of their tenure without the involvement of all of their cooperative’s professional advisers. Refinancing an underlying mortgage affects not only the monthly maintenance but also the market value of every shareholder’s apartment. The ramifications of making a mistake when refinancing are long-lasting and can be very expensive. Whether your new loan is big or small, short- or long-term, simple or complex, I strongly urge you to consult all of your cooperative’s professional advisers, including your attorney.
That said, I always like to draw a distinction between credentials and experience. Not all attorneys are well-versed in the refinancing process. Some have never closed a loan of any type, some have never closed an underlying mortgage loan, and others have not closed an underlying loan in years. A lack of recent and specific experience does not automatically mean that your attorney cannot close your loan. However, there is a strong possibility that an attorney who has closed many underlying loans will give you better advice, will close your new loan faster, and will encounter fewer “hiccups.” That experience might come at a higher cost than your regular attorney would charge but, I assure you, it will be money well spent.
So, if you are contemplating a refinancing of your cooperative’s underlying mortgage, by all means contact your regular attorney. They will tell you whether the terms of your existing loan allow you to refinance and, if so, what the prepayment terms (if any) might be. They also can give you a list of issues to consider as you formulate the type of new loan you want. You also should have a frank discussion with your regular attorney regarding their experience in closing underlying loans. If you decide to use a different attorney to handle your refinancing, your regular attorney can be very helpful in identifying and evaluating candidates. The overarching goal is for your cooperative to have the best legal representation for this very important transaction.
Some cooperatives do not have a regular attorney, either hiring someone different as each individual transaction presents itself or handling such issues on their own. When confronted with an underlying loan commitment, though, the boards of many of these cooperatives come to the (correct) conclusion that they need some professional help. Searching the Yellow Pages or online listings might turn up a few names to call, but a much better way to find a skilled attorney would be to ask friends, neighbors, and work colleagues for recommendations.
Should a board member perform any professional service for their cooperative beyond their board duties? It depends. Board members come from all walks of life and every profession. That diversity of knowledge and experience can be a great benefit to any board. Unfortunately, it sometimes can be a hindrance to effective administration and timely action. In those cases, it might be best to retain the expertise of an independent third party. However, there is no legal or ethical reason that a board member who is trained and licensed as an attorney could not close your cooperative’s new underlying loan. Likewise, there would be no conflict of interest, unless that attorney board member did something to benefit themselves at the expense of the cooperative or its other shareholders.
Closing a new underlying mortgage loan is not a terribly complicated process, but it does have many steps. Each of those steps must be completed to the satisfaction of the lender’s attorney before a closing can be scheduled. The cooperative’s attorney is responsible for satisfying most of those requirements. That is where past experience in closing loans comes into play.
Finally, unless there is some special situation to be addressed or complicated problem to be resolved, most new loans should close within forty-five days of commitment acceptance. The majority of my clients close in about three weeks, and one closed in three (very long and hectic) days! I hope that all of your closings go smoothly!
A: My answer is “no” … and “yes!”
“No” your condominium cannot get a mortgage loan. That’s because the legal structure of a condominium is fundamentally different from that of a cooperative. In a cooperative, an apartment corporation owns the entire building and acts as landlord to all the residents. Each resident receives a certain number of shares in the apartment corporation and a (proprietary) lease which entitles them to occupy their apartment. Since the apartment corporation owns all the real estate, it has something to mortgage.
In a condominium, every shareholder owns (and receives title to) their individual unit. There even is a separate tax “lot” assigned to each apartment. In addition, each shareholder receives an undivided, pro rata ownership interest in the common elements of their association (the lobby, basement areas, grounds, etc.). Since each shareholder owns their real estate, they have something to mortgage…and many shareholders in condominiums do just that. However, in virtually all cases, the condominium association itself does not own any real estate. Consequently, it has nothing to mortgage. So much for the “no” part of my answer.
Condominiums always have had a very valuable asset to offer as security for loans…their right to set and collect the monthly carrying charges from all shareholders. If the carrying charges are set at a level sufficient to pay all of the operating expenses of the condominium plus the debt service on a loan, most lenders would accept that right as collateral. Unfortunately, until 1997, New York State law prohibited condominium boards from entering into such transactions. However, since the law changed, financing has been readily available for condominium repair and improvement projects. That’s the “yes” part.
Unlike cooperative underlying mortgage loans, which are based principally on the value of the real estate used as collateral, loans to condominium associations are based almost solely on the cash flow generated by the association’s shareholders. Therefore, the terms of condominium loans are somewhat different.
The amount of a condominium loan will be determined largely by the cost of the project being planned, as well as the lender’s evaluation of whether all of the work can be completed within a relatively short period of time (one to three years). Depending on the nature and timing of your work, some lenders may hold back some or all of your loan until you actually need the money. The term of the loan usually will not be longer than five or ten years, and loan payments will be structured to repay the loan plus interest over that period of time. Current interest rates are in the range of 6%, so a $500,000 loan would have total monthly payments of about $5,600 (if repaid over ten years). That equates to an average of just $56 per month in a 100-unit building.
Other lenders will structure a loan in two pieces: a one-to-three-year credit line at a floating rate, followed by a five-to-ten-year fixed-rate loan. The interest rate on the credit line will be something like the prime rate plus 1.50% (3.25% + 1.50% = 4.75% today), with interest only paid monthly on the balance outstanding during the previous month. If a condominium is planning a lot of work, or one very large project, this format can save them a lot of interest.
The process for securing a condominium loan is pretty much like the process for obtaining any other loan. The lender will want to see, among other documentation, several years of financial statements, an operating budget for the current year, a shareholder list with monthly charges and arrears, a description of the work to be funded and related cost estimates, several years of apartment resale information, and a list of property personnel with wages. The entire process, from start to finish, will take sixty to ninety days.
So, while your condominium cannot get a mortgage loan like your cooperative neighbors, it can get a very good substitute to fund all of your building’s capital improvement needs. Good luck!
A: Your first question has a simple answer: yes. Ever since August 1997, when Governor George Pataki signed an amendment to the 1964 Condominium Act, condominiums and homeowner associations have been able to borrow money for repairs and capital improvements. Terms range from five to ten years, with either floating or fixed interest rates. Amortization rarely exceeds ten years (although I recently arranged a 15-year fixed-rate loan), making every loan self-liquidating over its term. As “collateral,” lenders take an assignment of the association’s right to collect common charges from the unit owners.
The biggest hurdle for most condos, though, is securing the required unit owner approval. Association bylaws typically stipulate that a large portion of the owners (usually 75%) approve any proposed loan. You’d be surprised how many debt plans fail this crucial test.
In that case, what’s a board to do? Some just forge ahead with an assessment and let the chips fall where they may. Owners either pay up or move out. Other boards try to complete the necessary work on an extended schedule to spread the financial burden over a longer period. That route often results in rework and higher cost. A few try to arrange home equity loans for any owner who wants or needs one, but that process (which depends on individual owner credit ratings) can delay the start of work.
Which brings me back to the loan option…and your second question. At some point in every condominium loan transaction I have ever done, someone has asked me the same question. My answer always was that combining individual lump-sum payments from some owners with a bulk loan serviced by the remaining owners was possible in theory, but very difficult in practice. A few boards actually tested the theory but, ultimately, each one gave up and closed a straightforward loan. Until this year.
Late last year, a medium-sized condominium on Long Island contacted me to help them fund a large façade project. These repairs had been necessary for a long time, but board after board had gotten bogged down in arguments over project scope, cost, and timing. Meanwhile, the deterioration of the building’s exterior accelerated. By last fall, it had reached the point where owner safety was a real concern. Finally, everyone in the building agreed that the work had to get done…right away. However, everyone did not agree on how to pay for the rather substantial bill.
Some owners did not want an increase in their common charges and had enough savings to cover their assessment. Some could pay their current charge, and maybe even a slight increase, but could not afford a lump-sum payment. Others owners were trying to sell their apartment and wanted to pay as little as possible. Needless to say, owner meetings were quite “lively.”
During one particularly heated exchange between a “loan” owner and a “no loan”owner, someone suggested that the board devise a solution that allowed each person to pay their share of the assessment according to their means. Suddenly, all of the steam evaporated from the room. A quick poll was taken to determine how many owners would pay their assessment up front which, in turn, established the amount of the necessary loan. The subsequent owner vote was nearly unanimous. Theory was about to become practice!
The final chapter in this story is still being written because, as the old saying goes: the devil is in the details…and there still are many details to iron out. First, the loan has not yet closed. Second, the condo’s attorney is still drafting the legal documents which will govern this novel arrangement. Then, there are several unresolved “kinks” in the administration and accounting of the loan payments. It also remains to be seen what adjustments might be necessary when owners of each stripe sell their apartments, how the respective new owners feel about the unusual financial obligations they may have inherited, and how each format affects apartment market value. So, stay tuned.
My advice for your board, and any other board considering such an option, is to proceed with caution…and heavy involvement of all of the association’s professional advisors. Also, finding someone who has been down this road a few times might help you avoid the inevitable potholes.
A: Over the last twenty years or so, I’ve either conducted or participated in myriad 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” – twelve mistakes that many boards make when refinancing their underlying mortgages. Avoiding these twelve mistakes won’t guarantee that you’ll get the best deal, but it will assure that your refinancing won’t be another “horror story.”
Top on 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 = 1.00%). 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 bororwers 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 5, 10, 15, 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 get reputations in the lending community as “shoppers” who aren’t serious. The second group needlessly squander 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 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 their existing lender, and close their new loan before their existing loan matures. If they miss that deadline, they can incur hefty fees and higher interest charges until they do close.
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 their intention to refinance. This notice must be delivered in a certain way at least thirty – and sometimes as much as ninety – 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 thirty or sixty 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 advisors. 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 (and, perhaps, an experienced mortgage broker) from the very start of the process.
I commend your effort to help your board make wise decisions. Avoiding the “Deadly Dozen” will get you a long way toward your goal of a successful refinancing.
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%) 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 5% 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 their own way, giving more or less weight to individual parameters. And each lender has a slightly different loan appetite from 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 their 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 loan, your cousin’s monthly maintenance is likely higher than yours!
A: The short answer is “No” - unless your board has extensive mortgage market experience. For most co-ops, the risk of making a mistake far outweighs the potential savings. Today’s financial markets are too volatile, and lender product offerings too numerous, for any lay person to evaluate completely. Your friend’s co-op may have saved some legal fees, and perhaps a brokerage commission, but I would be willing to bet that they did not get the best terms available from the market. It also is likely that they overlooked key provisions that may come back to haunt them in future years. (So, what did they really save?) Most co-op boards would not make any major decision without professional advice. Yet they forget that refinancing is perhaps the most important economic issue that any board will ever confront – affecting not only the monthly maintenance but also the market value of every shareholder’s apartment. With so much at stake, it truly pays to get the best advice money can buy. Call your managing agent, attorney, and accountant – as well as a skilled mortgage broker. Refinancing requires the complete involvement of all of the co-op’s professional advisors from start to finish!
A: Many boards are asking this same question. Fortunately, the answer for some is “yes.” What you are referring to is called a forward rate commitment (or, simply, a “forward”). This is a mechanism through which a borrower receives a lender’s promise today to provide a definite amount of new financing on or before a specific future date at a certain, fixed (or “locked”) rate.
Actually, there are two types of forward commitments. One is more commonly called an “early rate lock” and refers to the process of setting the interest rate on a new loan at or soon after application to guard against an increase in rates during processing. This type of forward requires a large “good faith” deposit (usually 2% to 3% of the loan amount) to hold the rate for no more than 30 to 60 days, but no other costs. The lender typically refunds the good faith deposit at closing, unless the borrower fails to close within the required 30 to 60 days. In that case, the lender usually keeps the deposit as a fee for having locked the rate.
The second type of forward became quite common in the world of new construction, where the success of a project often depends on the cost of permanent (fixed-rate) financing after the project has been completed and occupied. To improve their chances, many developers are willing to pay a lender a substantial fee up front to secure a fixed interest rate before construction even begins. Some developers prefer a higher fixed rate on their permanent loan instead of an up-front fee, and others negotiate some combination of up-front fee and higher fixed rate. Whatever the structure, these fees and higher rates function like a “premium” on an “insurance policy” against increases in interest rates during the construction period.
Forward commitments have migrated to other mortgage markets as yield maintenance prepayment penalties and prepayment lock-out periods have become more common. Therefore, depending on their individual circumstances, an early rate lock or forward commitment might make sense for some cooperatives. However, as is often the case with financial decisions, the answer for your co-op would come from “crunching the numbers.”
The benefit of locking in a lower rate today for a new loan to be closed sometime in the future is easy to grasp. The cost of doing this, though, is not so easily understood, especially if the new loan is scheduled to close many months in the future. The explanation begins with the concept of the time-value of money. Most people accept that a dollar received today is more valuable than a dollar received a year from today. How much more depends on current interest rates as well as the outlook for rates in the future. If we turn this concept around, and instead suggest that a dollar received a year from today is worth less than a dollar received today, we’ll be getting close to the way a lender thinks about early rate locks and forwards.
Predicting interest rates is risky business and, the longer the prediction, the riskier it becomes. That relationship is depicted graphically by the “yield curve,” which is a chart that plots interest rates against maturity (time). You can find the current yield curve in the financial sections of The Wall Street Journal, The New York Times, USA Today, and most other major newspapers.
Most of the time, the yield curve is a line that slopes upward to the right. This shape indicates the market’s demand for a higher rate of return (i.e., interest rate) as the length of investment (i.e., risk) increases. For example, investors usually would require a higher rate of return for a 7-year investment than they would for a 3-year investment. Similarly, a lender typically would charge a higher interest rate on a 10-year loan than it would on a 5-year loan.
Every once in a while (like now, for instance), the usual upward shape of the yield curve changes to a flatter, or even downward-sloping, line. Historically, a “flattening” of the yield curve indicated an unsettled market, and an “inverted” yield curve presaged a recession. However, in today’s global, 24/7, electronically-connected market, such changes function more as fodder for financial talk shows than as reliable economic indicators. Nonetheless, the current “flat” yield curve means that long-term interest rates are virtually the same as short-term rates. That means that now is a particularly good time to go shopping for a forward.
If you were looking for a new underlying mortgage today, every lender would be quite comfortable in quoting you an interest rate, and honoring that rate for 30 to 60 days until you close. If, however, you were looking to lock an interest rate today for a new underlying mortgage that you planned to close, say, ten months from now, the reaction from the lending community would be somewhat different. First of all, some lenders would not be interested in helping you at all because they do not offer forwards. The few lenders that do offer them would quote higher interest rates depending on how far into the future you planned to close. However, due to the flat yield curve, the forward premium would be less than if the yield curve had its usual upward slope.
At any point in time, the pricing of a forward reflects the prevailing interest rate market. Typically, the base spread of a forward is somewhat higher (10 to 20 basis points) than the spread on a loan for current delivery. Then, a premium (1 to 3 basis points) is added to the base spread for every month that closing is pushed into the future. So, if the spread on a new underlying mortgage for your co-op would be 100 basis points over the 10-year Treasury, if closed now, the spread for a 10-month forward on the same loan might be 130 basis points. The question for you, then, is whether you believe rates will increase by more than 30 basis points over the next ten months. If your answer is “yes,” you might opt for the forward commitment. If your answer is “no,” you’d wait out the ten months and look for a new loan then.
Since we now are in what most people think is an upward rate environment, many co-ops are talking about early rate locks and forward commitments. However, before getting too excited about “beating the market,” remember that any forward commitment (however short) is really nothing more than an expensive bet on the future trend of interest rates. In other words, it’s a gamble. If asked, most shareholders would prefer that their board not gamble with their financial future.
A: I commend your board on its forward thinking. So many boards rush into a refinancing with inadequate preparation and then wonder why they have problems and why the process takes so long. A well-prepared board with an organized file of building information should be able to complete a refinancing, start to finish, within sixty days.
So, how do you best prepare? The first step is to convene a meeting of your co-op’s attorney, accountant, and managing agent to discuss your plan and to enlist their aid in collecting all of the important information that you will need. Refinancing an underlying mortgage is the most important decision that your board will make during its tenure. It will affect not only the monthly maintenance of every shareholder but also the market value of every apartment. It is not something to undertake alone. For such an important transaction, you should have the best advice available.
Notice that I said that the first step was to collect information…not lender quotes. Specific loan proposals from lenders are of little value until you know what you want and are properly prepared to proceed. The information that you should assemble falls into three categories: building profile, financial status, and physical condition. Your building profile should contain the following items:
- A complete offering plan, with all amendments, plus the date of conversion;
- A breakdown of apartments by type (studio, one bedroom, two bedroom, etc.);
- A breakdown of apartments by ownership (owner-occupied, sublet, investor, sponsor);
- A description of the building (year built, number of floors, number of elevators, etc.);
- A list of building amenities (garage spaces, laundry room, storage, pool, etc.);
- A description of any commercial space;
- Photographs of the building, the inside of several apartments, and amenities (if any);
- Contact information for your attorney, accountant, and managing agent.
Your financial file should contain:
- Financial statements for the most recent three years (audited statements are preferred, but any formal statements prepared by a certified public accountant (CPA) are acceptable);
- An operating report through the last calendar month preceding the start of your lender search;
- A budget for the current year (plus a budget for the coming year should you begin your lender search in November or December);
- Recent bank statements showing the balance in the co-op’s reserve fund;
- A current maintenance roll by apartment;
- A current arrears report by apartment (along with an explanation of any significant delinquencies, i.e., reason, notices given, legal action taken, etc.);
- If available, a list of rents for any sublet, investor, or sponsor apartments;
- If applicable, a commercial rent roll with lease expiration dates;
- A list of apartment resales over the three previous years (unit number, number of shares, closing date, sales price);
- A list of capital improvements made to the building over the previous three years with approximate cost;
- If borrowing extra money for repairs or capital improvements, a list of those repairs and/or improvements with their approximate cost;
- The building’s current assessed valuation and the status of any tax abatements.
To accurately describe your building’s physical condition, you certainly will need input from your managing agent. However, you also might want to hire an engineer to assess the current condition of major building systems (roof, façade, heating plant, electrical service, plumbing, etc.) and expected repairs or upgrades over the coming years. Together, you can develop a projection of expenditures that will help you determine the best structure for your new financing and the total amount of new financing required to keep your building in optimum condition for the future.
You also could ask your attorney to order a preliminary title report and public records search to uncover any liens, violations, or other issues which could delay a loan closing. Having that information now will allow you to correct those items before you begin your lender search, or at least to be aware of them and plan how you could address them with a lender. Your attorney also should prepare a summary report regarding any outstanding litigation.
Lastly, you might want to check with your insurance agent to make sure that all of your coverages are appropriate and current.
I have given you quite a list. However, at some point in the refinancing process, virtually all of this information will be requested, either by a mortgage broker (if you use one), a loan officer, an underwriter, or the lender’s attorney. By assembling a complete package now, before you start your loan search, you will avoid many of the last-minute headaches that plague boards that are not as proactive as yours.
I wish you the best!
A: It would be very easy for me to say "Absolutely!" However, that might not be the best answer for your situation. In many ways, you're asking a question similar to the one that many boards ponder with respect to management of their co-op. Some buildings opt for self-management to save money. Some choose that route to maintain a greater level of control or provide a more personal level of service. Other boards don't want the extra work, but they also don't want to spend a lot of money. So, they hire the least expensive property manager they can find…and then usually get what they pay for. A relatively few boards want a very high level of service and are willing to pay for it. Each board makes its decision based on their building's finances, shareholder preferences, and other factors. The decision to hire a mortgage broker involves many of the same issues.
So, how do you decide? The first question to answer is whether any board member or shareholder is willing (and able) to dedicate a lot of their time, mostly during normal business hours, for the 60 to 120 days it will take to complete a refinancing. The second question is whether that person knows enough about the financial and mortgage markets to ask lenders the right questions and fully understand the answers. The third question is whether that person knows which lenders are active in the co-op underlying mortgage business, which would be most interested in your particular transaction, and whom to call within each of those institutions. If your answer to any of these questions is “no,” then you might want to consider hiring someone who meets all of these requirements.
Some boards ask their managing agent, attorney, or accountant to arrange their new loan. Is this a good idea? It absolutely is a good idea to involve each of these professional advisors in the refinancing process from the beginning to assure that you borrow the right amount, at the right time, in the right format. Each brings a different yet important perspective to the refinancing process and you would be foolish not to avail yourself of that valuable input. However, none of them may have the right combination of knowledge, skill, and experience to actually arrange the best loan for your building.
So, do you hire a mortgage broker? Since a very high percentage of new underlying mortgage loans are obtained through mortgage brokers, I could argue that a very high percentage of co-op boards feel that the services of a mortgage broker are worthwhile. However, that statistic doesn't necessarily mean that your building should hire one. If you do decide to hire one, a few words of advice might be helpful.
First, as with any profession, there are good mortgage brokers and not-so-good mortgage brokers. You would expect any mortgage broker to know all of the lenders, the types of loans that each one offers, all of the provisions that should be in any mortgage commitment to protect the borrower, and how to get the deal done quickly, efficiently, and without undue cost. Unfortunately, that expectation is not always met. Therefore, you might want to get a few recommendations from trusted sources. Even then, you'll want to thoroughly vet each candidate. Steer clear of any broker who professes ability to get special deals or rates from secret, foreign, off-shore, or investor sources. The co-op underlying mortgage market is relatively small (20 to 30 lenders total) and most are commercial banks, savings banks, or seller/servicers for Fannie Mae (FNMA), Freddie Mac (FMLC), or the U. S. Department of Housing and Urban Development (HUD). Not every lender is interested in every transaction. An experienced mortgage broker will know all of the lenders and, more important, which few would be most interested in making your new loan.
By far, the most important piece of advice that I would like to give to any board that is contemplating hiring a mortgage broker is this: HIRE JUST ONE. You can talk to several mortgage brokers to find the one you want to work with. However, until you make your selection, make it abundantly clear to each one that they are not authorized to represent your building and that they should not contact any lender to discuss your pending transaction. Some board members, accustomed to getting bids from several contractors before making a decision, assume that they should follow the same process when looking for a mortgage broker. You do not want bids from mortgage brokers. They don't have any money and can't give you a loan. You want bids from lenders because they (to paraphrase Willie Sutton) have the money and are in the business of making loans. Once you've chosen your broker, give them a written authorization to contact the lending community on your behalf. I also recommend making this authorization "exclusive" to maximize the broker's leverage in negotiating with lenders to get you the best possible loan.
I apologize if this seems a long-winded answer to your very simple question. However, the choice of any professional to represent your co-op is a very serious issue with wide-ranging implications. Since the refinancing of your building's underlying mortgage loan may well be the most important decision that you and your fellow board members will make during your tenures, affecting not only your monthly maintenance but also the market value of every shareholder's apartment, you should give utmost attention to the decision of whether to hire a mortgage broker. I wish you the right choice for your situation.
A: Congratulations on being elected treasurer! Your fellow shareholders have entrusted you with one of their most important investments – their home! I commend your sense of dedication and willingness to seek professional help.
Refinancing an underlying mortgage is the most important decision that a board member will ever make. It will affect not only the monthly maintenance of every shareholder, but also the market value of every apartment in your building. It is a very complex and expensive process, so it is not a step to be taken lightly – or alone. The right professional guidance can make a real difference.
Believe it or not, many boards fail to contact their professional advisors until after they have signed a commitment letter. In fact, that contact often comes in the form of a cover letter on a copy of the commitment instructing them to “close it as soon as possible!” Better late than never, I suppose, but such boards are not taking full advantage of their advisors’ knowledge and years of experience. With a lender already chosen and the major terms of the new loan already finalized in a commitment, such boards have seriously limited the ability of their advisors to fully protect their co-op’s interests.
Boards that fail to contact the appropriate professional advisors before and during their refinancing can cost themselves a lot of time and money. Incidentally, “saving money” is the reason most often cited by co-op boards who get themselves into this kind of “do-it-yourself” trouble. But, as almost always happens in do-it-yourself projects gone awry, the money co-op boards thought they would save ends up costing them tenfold. However, by calling the right advisor at the right time, co-op boards can protect themselves from expensive surprises and make the refinancing process less labor-intensive and more cost-effective.
If your co-op doesn’t have professional advisors or needs to hire new ones, your board should get recommendations from other boards and organizations like the Council of New York Cooperatives and Condominiums. These individuals know the industry and can suggest qualified professionals to interview. To get any important activity off to a good start, it always pays to have a full team of professional advisors on your side. This is especially true of refinancing.
Since your board already has decided to refinance, you should schedule a meeting at which the following professional advisors should be prepared to discuss related issues within their realm of responsibility.
- Managing Agent -Other than your super or perhaps a long-time resident, your property manager knows your building better than anyone. They can advise you regarding future increases in operating costs and taxes, tell you which repairs or improvements might be needed and when, and help estimate their cost. This information is essential to determining the right amount for your new loan.
- Attorney -Your attorney should review all of the documentation for your existing underlying mortgage to be sure that no provisions either prohibit refinancing outright or result in unaffordable prepayment penalties or other expenses. Assignment and existing lender notice requirements should be reviewed to prevent expensive delays later in the refinancing process. Your attorney also is the best person to review loan applications and commitments, as well as estimate the closing costs for your new loan.
- Accountant -Ask your accountant for a comprehensive report on your building’s current financial position as well as a 5-year (or, even better, 10-year) projection of the effects of inflation and other increases on your co-op’s budget. To do this, your accountant will have to work closely with your property manager.
- Engineer -Hire a professional engineer to thoroughly inspect your building’s major components and then prepare a schedule of repairs and capital improvements over the next five and ten years, together with estimated costs. The engineer also can help you prioritize projects to make sure the most urgent jobs get done first. These cost estimates and schedules should be added to your accountant’s financial plan.
- Mortgage Broker -Refinancing requires a tremendous amount of work and documentation. A skilled mortgage broker knows exactly what information is needed, how to collect whatever the board doesn’t have or can’t find, and then how to package it for the most favorable presentation. An experienced broker is active in the market every day, knows what loan products are available, what structures are possible, and which lenders will be most competitive for your new loan. Most importantly, he can help the board evaluate the terms of each loan offer, highlight the often-overlooked “fine print” details, and explain the relative benefits of each lender. Finally, since the broker doesn’t get paid until your new loan closes, he has a vested interest in monitoring every aspect of your transaction until the job is done. You could try to do all of this by yourself, but a good broker will do it better, faster, and cheaper.
Most people like surprises – but only if they involve flowers, dinner reservations, and tickets to a Broadway play. In the refinancing world, surprises are rarely pleasant. By getting the right help at the right time, the only surprise you’ll get is how smoothly your refinancing went!
A: You find a good mortgage broker in the same way you find a good managing agent, attorney, or accountant. Ask your professional advisors for a recommendation, interview two or three candidates, and check their references. Trust your gut. The one who “feels” right will more likely do the best job. And remember, hire just one broker (never two) to represent you. The competition you want is between lenders to make the loan not brokers to get a commission.
A: Unless your existing loan has a very high interest rate, or you need extra money for major repairs, you should enter the market no earlier than 18 months and no later than 6 months before the maturity of your current loan.
A: The simple answer to your question is that your co-op should borrow what it needs but no more than what it can repay within an operating budget that is (a) balanced (i.e., income equals or exceeds expenses, including debt service) and (b) affordable to all (or most) of your shareholders. This amount typically includes the outstanding balance on the existing mortgage loan, any credit line or other debt, closing costs, and (sometimes) additional funds for capital improvements.
The more technical answer is that “it depends.” Most lenders limit underlying mortgage debt to some percentage of a building’s value…as a rental (not as a co-op). This value usually is determined by an appraisal of your property (performed by an expert with the MAI designation) using estimated market rents, an assumed vacancy rate, adjusted expenses (to account for inflation, etc.), customary third-party management fees (not necessarily the amount you pay your managing agent), reserves for repairs and replacements, and a contingency. The “net operating income” resulting from this calculation is then capitalized using some market-based investment rate of return. I’ve rarely seen loans above 80% of this fictitious value, and many lenders stop at 65%. All lenders give better pricing as the loan to property value ratio (“LTV”) drops, with the very best pricing given to buildings whose loans are in the 5% - 10% range.
In the “old days” … and I’ve been around long enough for that term to have real meaning … lenders did use rules of thumb like $X per unit. All of those metrics have fallen by the wayside. LTV is the key determinant for most loans today.
I suspect that this answer may be helpful from an educational standpoint but, to give you a specific dollar amount or range, I would need some building-specific information.
A: A basic tenet of finance is that long-term assets should be financed with long-term money. Further, a co-op board has a fiduciary responsibility to its shareholders to establish a prudent financial structure for their co-op and operate within an appropriate budget. Variable rate debt, like most credit lines, exposes the co-op’s budget to interest rate risk and potentially dangerous increases. Therefore, any long-term asset like a new roof should be paid for with a loan whose term is roughly equivalent to the expected service life of the asset.
A: The lending community uses lots of jargon. One of the most common terms is “LTV’, or “loan to value”. LTV is almost always expressed as a percentage, and that percentage is calculated by dividing the proposed new loan by the estimated value of your property. Despite the “no money down – 100% financing” hype of late-night infomercials, most lenders limit their lending to some lesser percentage of a property’s value, usually no more than 75%. In addition, many lenders tie their pricing to LTV, with lower LTV properties getting more favorable rates than those with higher LTVs.
The issue of LTV often causes a problem because borrowers and lenders view a property’s value from different perspectives. When most co-op residents think of their building’s value, they typically multiply the most recent apartment sales price by the number of units in their building. For your co-op, you might use an average sales price of $325,000 per apartment times the nine units in your building to arrive at a “value” of $2,925,000. So, the new loan of $1,400,000 that you’ve been seeking -- which would give you an LTV of 48% -- seems perfectly reasonable.
Lenders, on the other hand, calculate value a little differently. A lender’s biggest fear is that a borrower will not make their monthly payment, forcing the property into foreclosure. Foreclosure is a legal process through which a lender can take a property away from the borrower by exercising certain rights acquired under the mortgage that the borrower signed at the loan closing. However, lenders do not want to own property. Therefore, whenever they acquire a property through foreclosure, they almost always put it up for sale.
So, when lenders think about value, they don’t care what the borrower says their property is worth, or even what the borrower may have paid for it. From the lender’s perspective, a property’s value is the price that it will bring in a quick foreclosure sale. And that value is a little more difficult to determine…especially when the borrower’s property is a cooperative apartment building.
When a cooperative defaults on its underlying mortgage, the lender most likely will move to foreclose. If completed, the foreclosure will dissolve the apartment cooperation and convert the property to a rental. Whether any lender actually could accomplish such a conversion in today’s legal and political environment, is fodder for another article. Nonetheless, that’s what goes through a lender’s head when they think about value.
So, let’s look at your building through a lender’s eyes. First, we’re going to pretend that your building is a rental and ascribe a fictitious rent to each of your apartments. If we assume that all nine of your units rent for an average of $3,000 a month, the maximum possible gross income for your building would be $324,000 per year. Most lenders will expect that some of your apartments will be vacant at least some of the time and adjust the total possible rent by some amount (say, 5%) to account for tenant moves, market slumps, and other rent reductions. After allowing for these factors, we have an adjusted gross income of $307,800.
Your current operating expenses run approximately $170,000. Most lenders will increase various line items (like real estate taxes and heating oil) to allow for inflation (let’s assume an average increase of 6%). They most likely will increase your insurance coverage. They also will add a full-service management fee (about 5% of adjusted gross income) and an amount for maintenance, repairs, and replacements ($1,000 per unit per year or more). After making these adjustments, your total operating expenses will come to $204,590. If we deduct that amount from the adjusted gross income, we are left with a net operating income (or “NOI” in lenderspeak) of only $103,210.
This NOI represents the annual cash flow that an investor would receive if they were to buy your building (paying all cash). The amount that a real estate investor would be willing to pay depends on the rate of return that they require for a new investment. If an investor wanted an annual return of 7%, we could estimate the value of your building by dividing the NOI of $103,210 by 7% to get $1,474,429. Lenders refer to this calculation as “capitalizing the net operating income” and they call the 7% return a “cap rate”. If we then apply the common maximum LTV of 75%, we get a maximum new loan of $1,105,821…let’s round that to $1,100,000. It’s pretty clear that a new loan of $1,400,000 is excessive…at least to most lenders.
Knowing why lenders are rejecting your loan request is, I suspect, of little comfort. However it might help you find a solution. For example, you might assemble data on apartment rentals in your neighborhood. If you can document higher rents than what the lender assumed, you might get your loan amount increased. You also should take a hard look at each line item in your operating budget to capture any cost savings. Lastly, you can borrow less and either scale back your capital plans or supplement your smaller new loan with shareholder assessments.
Thanks for your question!
A: Most commitment letters will specify a minimum appraised value for the borrower’s property. This minimum value was calculated during the underwriting process and is related to the new loan amount. If your property appraises for less than the minimum value, you have three options: borrow less, apply to another lender, or abandon your refinancing effort. Before doing any of these, however, I would request a meeting with the loan officer, the appraiser, and the co-op’s managing agent and accountant to review the backup information used in the appraisal. Such a meeting very often uncovers overly conservative assumptions, inappropriate comparisons, or outright mistakes which caused your building to be undervalued.
A: It may be scant comfort to know that almost all small co-ops encounter the same problem. One reason comes from the lender’s perspective. It takes the same amount of work…and sometimes more…to do a small loan as it does to do a big one. However, the amount that a lender can charge for a loan tends to equal a relatively constant percentage of the total loan amount. Therefore, as loan size drops, so does the lender’s income and, at some point, it doesn’t make economic sense to do a deal. This is especially true for large lenders like the ones you’ve been calling.
Another reason comes from the market. Prior to 2009, there was a fairly active secondary market for small co-op loans. This gave lenders a ready buyer for their small loans at a decent profit. And, because the secondary market pooled lots of small loans into a big package for sale to large institutional lenders, smaller co-ops received interest rates very close to those on loans to much bigger buildings. Unfortunately, that portion of the secondary market evaporated in the subsequent financial collapse. Consequently, the few lenders still active in the smaller end of the underlying mortgage market now originate loans only for their own portfolios.
So, today, in addition to all of the regular lender requirements, small co-ops…those with fewer than, say, ten units…face special challenges when searching for a new loan. In fact, if a building has fewer than five units, there may be only two…or perhaps three…lenders willing to do a loan. With such a small universe of lenders, co-ops like yours are in a very poor negotiating position.
Another challenge is cost. Because all underlying mortgages are commercial loans, lenders typically require the same documentation for small loans as they do for big ones. That means a full commercial appraisal (which is much more extensive than the one- or two-page report that individual apartment buyers may have seen and can cost $3,000 or more), an engineering report of the building’s physical condition (about $2,500) , and an environmental risk assessment ($1,000 to $1,500). Then, there are legal fees…for both the co-op’s attorney and the lender’s (at least $3,500 per side), title insurance (about $3 per $1,000 of loan amount), a survey update (about $500), searches of the public records for liens and violations (another $300 to $500), and miscellaneous items (say, $200 to $300). Some lenders charge origination fees (also called “points”) of 1% to 2% of the total loan amount, but some do not. If you hire a mortgage broker, their fee can be 1% of the total loan amount (and sometimes more). And, of course, if the co-op is increasing the total amount of debt on their building or, as in your case, taking out a brand new loan, there is mortgage recording tax (from 1% of the amount of “new” money in the counties outside the City to 2.05% in the five boroughs). That means that a new $200,000 loan like the one you are seeking could have total closing costs in the range of $15,000 to $25,000.
A third challenge is the interest rate. As I mentioned earlier, virtually all small co-op loans are originated by lenders for their own portfolios. These lenders, which themselves tend to be smaller in size, usually have a higher cost structure, and that is reflected in the interest rates they charge. That’s why smaller co-op loans like the one you want get interest rates that, depending on length (or term), are typically between 2.00% and 4.00% higher than those on bigger loans.
After painting such a discouraging picture, I’d like to leave you with a bit of good news. There are several lenders that will give you a new loan. And, if you have trouble finding them, I know at least one good mortgage broker who can lead you straight to them.
A: Co-op board members, just like the management of any corporation, often confront difficult or controversial decisions. However, unlike the rather anonymous shareholders of other corporations, co-op shareholders have the familiar faces of friends and neighbors. This familiarity adds another dimension to a co-op board member’s decision-making, but it does not diminish their fiduciary responsibility to run their property in a prudent manner for the benefit of all shareholders -- not just the vocal ones or the ones down the hall. The previous board seems to have forgotten this fact. You clearly understand it.
First, all board members…and shareholders, for that matter…must understand that their cooperative is not some form of residential welfare state. It is a real business, and it must run like one. To that end, board members need to bring the same careful planning, hard work, and sound judgment that they use in their “day job” to the management of their co-op. To do any less is a breach of their fiduciary responsibilities.
A new underlying mortgage certainly could provide money for needed repairs. But taking that step without careful analysis could put you deeper in the hole. Therefore, your second step should be meetings with your managing agent and accountant to review your property’s performance over the past five years. Look for trends and problem areas, and also assess how past emergencies were handled. Remember the old saying that “those who do not study history are doomed to repeat it.”
Third, prepare a realistic budget for each of the next five years. Each year’s budget should include allocations for routine and preventative maintenance, contributions toward major capital improvements, plus an allowance for unexpected items. For reliable projections of future capital items, hire an engineer to perform a roof-to-cellar inspection of your building. The engineer’s report should contain four categories:
- Work needed now.
- Work needed over the next 5 years.
- Work needed in years 6 to 10.
- Work needed after year 10.
Within each category, the engineer should list items in their order of importance, together with their estimated cost. Why a 10-year period? Because most underlying mortgages run for at least that long. Therefore, if you later decide to refinance, you better know your capital needs over that period so you don’t run short of funds.
Fourth, involve your shareholders. Find out what owners are thinking by contacting them on a regular basis to gather their opinions on budget priorities, spending plans, and policy changes. Understanding the relative importance of shareholder concerns will guide you toward decisions that will be supported by a majority of residents. It rarely is possible to satisfy everyone; but giving shareholders the opportunity to express their fears and desires will go a long way toward gaining acceptance for the tough decisions you’ll be making. Without that acceptance, achieving your goal of a solid building with sound financials will be much more difficult.
Finally, combine all of the information provided by your managing agent, accountant, and engineer to develop a long-term plan for your building. This plan should include specific, measurable goals. Some of my clients have set goals like:
- Sustain higher apartment values relative to neighboring properties through rigorous cost control, regular cosmetic improvements, and annual preventative repairs. Limit annual maintenance increases to the greater of the CPI increase, or 3%.
- Build a working capital reserve equal to three months of budgeted operating expenses, plus a separate reserve for roof and boiler replacement. Pass a special assessment to fund the roof and boiler repairs, and collect it over the next eighteen months. Begin work the following spring.
- Complete all repairs and system upgrades recommended by the engineer within three years. Obtain needed funds through a mortgage refinancing before the end of next year.
Your goals will be different, but you must have them to assure your success. A long-term plan provides the framework that channels every board decision toward your ultimate objective.
Planning is hard work, but it is relatively painless. Implementing your plan, on the other hand, will be more challenging. However, by enlisting professional help from the start, educating your shareholders up front, and then communicating with both groups regularly throughout the process, you will maximize your results and minimize shareholder resistance. Keep your eye on your goal. A comprehensive, financially-sound, long-range plan is one of the most valuable legacies that a board can leave to future boards. Your work will not be easy, but it will have far-reaching and long-lasting effects on both the financial stability of your co-op and the market value of every unit in your building.
I commend your dedication…and wish you every success!
A: That’s literally the $64,000 question. In fact, depending on the size of your existing loan, it could be a much more expensive question. It’s also one that lots of people are asking these days. And the answer, as it is in so many cases, “It depends.”
Let’s address the prepayment penalty first. Many shareholders have an emotional block against prepayment penalties. They feel that an evil lender snuck the penalty into their loan documents and, under no circumstances, will they give the lender the satisfaction of collecting it. Such nonsense makes for spirited debates at shareholder gatherings, but it just that: nonsense. Another myth is that some loans don’t have prepayment penalties. For the record, virtually all underlying mortgage loans have some sort of prepayment penalty.
A loan note and mortgage are contracts between the lender and the borrower. Neither side can break the contract without the consent of the other, regardless of changes in the market. For example, if interest rates go up, the lender can’t break the contract and charge the higher rate. Likewise, if rates go down, the borrower can’t cancel the deal to get a lower rate. However, a lender might allow a borrower to break the contract in exchange for a fee, and this fee has the perhaps unfortunate name of “penalty.” It is useful to remember that all of this was disclosed in the original loan documents which both sides signed at closing.
For most loans originated over the last ten years or so, this fee is calculated to equal the present value of the interest income that the lender will lose if the borrower breaks the contract and prepays the loan. For example, if a building had a $2,000,000 loan for 10 years at 7% (and let’s assume that the loan is “interest only” for simplicity), and the board decides to prepay the loan at the end of year six. This will deprive the lender of interest income for the four years remaining in the original loan term. The lender will take the $2,000,000 and invest it in U.S. Treasury securities that have a 4-year maturity and an interest rate of, say, 2% to make up part of that lost interest income. So, the net loss suffered by the lender will be the 7% less the 2% times the remaining four years of the loan, adjusted by the time-value of money…about $384,000! Ouch!
So, why would anyone ever prepay a loan? Because they can save more than the penalty by replacing their existing loan with a new loan at a lower rate. And how much lower does that new rate have to be? There is a frequently-quoted rule-of-thumb that says that the difference between the old and new rates must be at least 2% for refinancing to make sense. Unfortunately, that frequently-quoted advice is frequently wrong. The correct answer requires a calculator.
Let’s go back to our example. The penalty for prepaying our $2,000,000 7% loan four years early was about 384,000. The new interest rate would have to be something less than 2% for refinancing to make sense. So, if this were your building, you would have to wait until you were closer to maturity before refinancing could make sense.
A: Before the law changed in 1997, condominium buildings (unlike cooperative apartment buildings) had few options when it came to raising money for capital improvements. Due to their legal structure, condominiums had no real estate to offer as collateral for a loan (as did cooperatives), and condominiums were prohibited from assigning any of the common charges they collected from unit owners to service debt. However, condos could acquire the needed funds by increasing their common charges or levying assessments on the unit owners.
Neither of these alternatives, though, was very popular. Moreover, raising funds through increased common charges took a long time, which usually made it impractical for any significant project. The other choice, collecting money through assessments, was somewhat faster, but assessments sometimes had undesirable side effects. Large and/or repeated assessments usually depressed unit market values and often made individual unit mortgages more difficult to obtain. Also, a certain percentage of unit owners could not afford these new obligations and fell behind in their payments. This caused their association to incur additional legal expenses for collection or foreclosure actions.
Some condominiums were able to secure financing because they owned their superintendent’s apartment or a separately-deeded community center and were able to offer that property as collateral for a mortgage loan. However, these assets rarely supported much more than a relatively modest amount of debt. Still other condominiums got very creative and built financing into the contract prices for their needed repairs, but that usually cost quite a bit more than traditional loan rates and was not always available from the most competitive contractors. So, funding capital improvements was a difficult problem for most condos.
Then, in 1997, the New York State legislature changed the condominium law to allow associations to assign their revenue from unit owner common charges to the payment of interest and repayment of debt. This simple change made financing much easier for most condominiums. Now, they could quickly borrow the money they needed for repairs and improvements and spread the unit owner burden over a much longer period of time. Whoever told you that condos can’t borrow is very much out of date.
So, how does one of these newfangled condo loans work? The association applies to a lender for a condo loan much like a cooperative apartment building would apply for new underlying mortgage loan. The lender will want lots of information including three years of financial statements, a list of all unit owners and their respective common charges, an explanation of any owner arrears or foreclosures, a list of unit resales during the most recent three years, a description of past capital improvements, an explanation of any outstanding litigation, and details about the planned use of the loan proceeds. Once the lender has reviewed all of that documentation, there might be a request for additional information to explain or justify certain aspects of the association’s profile. If everything passes muster, the lender will issue a commitment that defines the specific terms and conditions of the new loan. The association’s attorney will review this document to make sure that the condo’s interests are protected and then schedule a closing.
Actually, the association should involve their attorney even before contacting any lenders to identify the steps that the board must take to comply with the association’s by-laws and other regulations. Many associations require that at least 75% of the unit owners approve any financing before a new loan may be closed. After a commitment has been issued is the wrong time to hold that vote.
I also should explain two other aspects of condo loans. First, virtually all condo loans are self-liquidating (i.e., they must be fully repaid) over five to ten years. This makes the monthly payments significantly higher than they would be if the loan were interest-only or amortized over 30 years (like many cooperative underlying mortgage loans). Second, in the event of default (i.e., you don’t make your loan payments), the lender steps automatically into the shoes of the board and collects the monthly charges directly from the unit owners. The lender will take whatever amounts are due on your loan and give you whatever is left. The vast majority of associations meet all of their financial obligations. However, you should understand what will happen if you don’t.
Lastly, I strongly urge you to consult all of your association’s professional advisers before you begin the borrowing process. They will guide you to the right decisions and make sure that you borrow the right amount on the right terms for your particular situation.
A: Reading about your fellow board members reminds me of the old Johnny Mercer tune. While a new underlying mortgage certainly could provide funding for a new boiler, what if you need more money for some other improvement or repair a few years down the road? Where will that come from? Isn’t it more than a little foolish to rush into such an important transaction without proper planning and preparation? Even with a low interest rate, a poorly-structured loan, or one that is either too small or too large, could have a damaging effect on both the monthly maintenance and market value of every shareholder’s apartment. I think that your instincts are spot on. Before making any major decisions, your board should first develop a thorough understanding of your building’s current physical and financial condition.
As a first step, I recommend a meeting with your managing agent and accountant to review your property’s performance over the past five years. What went right, and what didn’t? Look for trends and problem areas, paying special attention to how past emergencies were handled. Ask each of them for their top three recommendations for the future.
Step two would be a roof-to-cellar inspection of your building performed by an experienced engineer. The engineer’s report should contain four categories:
- Work needed now.
- Work needed over the next 3 to 5 years.
- Work needed in years 6 to 10.
- Work needed after year 10.
Within each category, the engineer should list items in their order of importance, together with their estimated cost. Why a 10-year period? Because most underlying mortgages run for at least that long. Therefore, if you later decide to refinance, you better know your capital needs over that period so you borrow the right amount.
Third, you should prepare a realistic budget for each of the next five years. Each year’s budget should include projected operating expenses, current debt service, allocations for routine and preventive maintenance, contributions toward a general reserve fund, plus an allowance for unexpected items. This will allow you to project monthly maintenance over the next five years and then to determine whether your fellow shareholders could support such payments. The picture painted by those calculations will tell you whether you could take on additional debt to fund a capital improvement plan.
Fourth, involve your fellow shareholders. Find out what they think by contacting them on a regular basis to gather their opinions on budget priorities, spending plans, and policy changes. Understanding the relative importance of shareholder concerns will guide you toward decisions that will be supported by a majority of residents. It rarely is possible to satisfy everyone; but giving shareholders the opportunity to express their fears and desires will go a long way toward gaining acceptance for the tough decisions you’ll be making. Without that acceptance, achieving your goal of a solid building with sound financials will be much more difficult.
Lastly, if you do decide to refinance, be sure to involve your attorney in the early planning stages. They will review your existing loan documents for things like prepayment terms and notice requirements. They also will ensure that any loan application includes everything you want and that any commitment includes everything you need. And, of course, they will guide you through the closing.
Such planning and preparation are essential to the prudent management of your cooperative. All of your board members…and shareholders, for that matter…must understand that their cooperative is a real business. To be successful over the long term, it must run like one. To that end, board members need to bring the same careful planning, hard work, and sound judgment that they use in their “day job” to the management of their co-op. To do any less is a breach of their fiduciary responsibilities.
I commend your dedication, and that of your fellow board members. Keep your eye on the goal. A comprehensive, financially-sound, long-range plan is one of the most valuable legacies that a board can leave to future boards. Your work will not be easy, but it will have far-reaching and long-lasting effects on the financial health of your co-op.
I wish you every success!
A: With very rare exception, all underlying mortgages have prepayment penalties. Many people think that this is unfair and that every borrower should be able to repay their loan whenever they want without penalty. From the borrower’s perspective, free prepayment makes perfect sense. However, from the lender’s point of view, it does not. To be fair, if the borrower can prepay whenever interest rates go down, then the lender should be able to demand loan repayment whenever interest rates go up. Most borrowers would strongly object to that.
The logic behind prepayment penalties is a little easier to understand if you think of a loan as an investment or a contract. Under a loan agreement (usually referred to as the “note”), a lender agrees to provide the borrower a certain amount of money (the “principal”) for a specified period of time (the “term”) in exchange for a rental fee (the “interest”). This is much like an investor who buys a certificate of deposit (CD) from a bank expecting to receive a fixed amount of interest until the CD matures. If, prior to the CD’s maturity date, the bank were to cancel it and return the investor’s money, the investor could rightfully expect some form of compensation (or penalty) from the bank for breaching their agreement.
When a borrower closes a loan, they enter into a contract with the lender, and this contract comes with certain rights and obligations for each party. The borrower has the right to use the lender’s money for the duration of the loan term and the obligation to make the required payments of interest (and sometimes principal) when they are due. The lender, having made an investment in the borrower, has the right to expect the rate of return that was specified in the contract (i.e., the interest rate) for the duration of the loan term. If the borrower decides to breach the contract by prepaying their loan before the maturity date, the lender is entitled to compensation in the form of a prepayment penalty.
Most banks are in the money business – receiving money in the form of customer deposits (for which they pay a rental fee or interest) and disbursing money in the form of loans (for which they collect a rental fee or interest). A typical bank’s survival depends on maintaining a positive spread between the interest they collect from borrowers and the interest they pay out to depositors. This balancing act is relatively easy when market interest rates are stable but it becomes more difficult when they are not. As interest rates rise, many depositors cash in their lower-rate CDs to reinvest in something that pays them a higher return. When interest rates fall, many borrowers prepay their loans to refinance at a lower rate. CD cancellation fees and loan prepayment penalties help banks cover the costs of these disruptions.
In today’s underlying mortgage market, not every loan has a yield maintenance prepayment penalty. I am old enough to remember when the choice for most co-op boards looking for a new underlying mortgage was either a 5-year balloon loan with one 5-year renewal option or a 30-year self-liquidating loan. The 5-year loans typically had prepayment penalties based on a declining percentage of the outstanding loan balance (e.g., 5% in year 1, 4% in year 2, 3% in year 3, 2% in year 4, and 1% in year 5). This schedule repeated if the borrower exercised their option to renew their loan for a second 5-year period.
The 30-year loan usually prohibited prepayment (or imposed a yield maintenance penalty) for the first 15 years. After that period, the prepayment penalty dropped to 1% of the outstanding balance or, in certain cases, zero. By the time I started my mortgage brokerage firm about 25 years ago, more lenders had entered the market with intermediate products of 10 or 15 years. Unfortunately, almost all of them adopted yield maintenance as their prepayment formula. However, many boards were so happy to have an intermediate-term alternative to the 5- and 30-year loans that they overlooked the yield maintenance prepayment penalty. In fact, the 10-year maturity soon became the most common form of underlying mortgage, accounting for more loans than all of the other maturities combined. That still continues to be the case today.
While yield maintenance remains very prevalent in underlying mortgage loans, competition among lenders has resulted in a number of interesting alternatives. For a new 10-year loan, some lenders might impose yield maintenance for the first five or seven years and then switch to a declining percentage. Other lenders have abandoned yield maintenance altogether in favor of a declining percentage formula for the entire term (e.g., 5%, 5%, 4%, 4%, 3%, 3%, 2%, 2%, 1%, 1% or 5%, 5%, 5%, 4%, 4%, 4%, 3%, 2%, 1%, 0%). Even if a lender offers you a loan with yield maintenance, you always should ask whether there is another option.
As a final note, I would like to mention that prepayment penalty formulas are relevant only if you have to prepay. Prudent financial planning, annual budgeting of contributions to the co-op’s reserve fund, and second mortgage credit lines can obviate the need to prepay an existing underlying mortgage for most buildings. And, when interest rates are very low (as they are now), go for the best interest rate regardless of the prepayment penalty formula because the likelihood of higher rates should you have to prepay is extremely low.
A: Refinancing your underlying mortgage should not be your automatic response to the need for capital improvement funds. It is a very expensive way to solve that problem. You first should first exhaust other options such as an increase in maintenance, a special assessment, sale or lease of excess building property (commercial space, roof antenna rights, parking areas, etc.), loans from wealthy shareholders, contractor financing, credit lines arranged through your managing agent, or additional funds from your existing mortgage lender. I discuss even more options in an article I wrote for the March 1997 issue of Habitat Magazine, entitled Building Operations - A Financing Alternative. However, if these steps already have been taken or are impractical in your situation, refinancing your underlying mortgage may be the right solution. In that case, give me a call for a free consultation!
A: Absolutely not! However, without visiting your building, discussing your planned improvements, and reviewing your cooperative’s financial records, I hesitate to give you a specific time frame. Nonetheless, I can’t imagine a scenario that would take anything like six months.
Refinancing an underlying mortgage is a complex process, one that requires thorough planning and careful execution. My guess is that your new board member’s former building failed on one or the other, or both. While I have completed transactions in as little as three days, most take around two months. Assembling all of the necessary information, deciding on the amount, term, and amortization schedule, and then sorting through the various lenders and loan offers will consume at least half of that time. Reviewing the commitment and closing your new loan will take up the balance.
Virtually all lenders have a formal loan approval procedure that starts when a signed application is received, then passes through “underwriting,” and culminates in the issuance of a “commitment.” Each lender has its own set of forms that comprise the “application.” These forms help organize all of the information that the lender needs to determine whether the proposed loan makes economic sense. None of the information requested is that complex, although you might have to call a few of the shareholders who have lived in the building for a long time and/or several of your building’s advisors to get some of it.
Some forms require no more than a date and the signature of one of the co-op corporation’s officers. These typically are authorization forms that give the lender permission to verify certain information. For example, a loan verification form asks your existing lender for information regarding your co-op’s current loan (lender, address, loan number, contact person, phone number, etc.) and your payment history. You should be ready to explain any late payments or other credit issues. Deposit verification forms allow the new lender to confirm that the checking, savings, money market, and investment account balances that the co-op reported are accurate.
Some lenders also send an environmental questionnaire that helps them determine whether the co-op’s property presents any environmental risks. While board members and managing agents may not be able to answer every question on such a form, they should be as complete and honest as possible. If the co-op’s questionnaire provides enough information, the new lender may waive any further environmental investigation (thus saving the co-op substantial time and expense). If not, the lender most likely will order a follow-up inspection by a licensed environmental engineer to evaluate potential hazards.
The next step in the loan approval process is “underwriting.” During this phase, the loan officer and other lender personnel evaluate all of the information that the co-op supplied on their application and various accompanying forms, as well as any other facts provided. Annual accounting statements paint a picture of the co-op’s financial condition and indicate whether the co-op can carry the new debt and ultimately pay it back. Additional supporting information will come from a credit report, appraisal, engineering inspection, and environmental assessment that the lender might order from third parties. The co-op’s credit report is much like what would be requested for an individual. It lists the co-op’s outstanding loans, liens, judgments, and other obligations as well as their corresponding payment histories. All lenders want to be sure that potential borrowers pay their bills on time.
An appraisal (if required) will determine three hypothetical values for your co-op: its replacement value (the cost to rebuild the building today on the same or similar lot), its sale value (based on recent sales of “comparable” properties), and its investment value (based on the income stream your building would produce if it were a rental). Lenders consider all three values, but they give the most weight to your co-op’s value as a rental because, if your co-op doesn’t make its payments and the lender must foreclose, your co-op would revert to rental status. The appraisal forms the basis of the lender’s loan-to-value ratio, or “LTV,” calculation. Each lender has a maximum LTV limit, usually around 65%.
Many lenders also hire a professional engineer to thoroughly inspect the co-op’s property to make sure that no significant repairs are needed. Serious defects and building department violations usually must be corrected before (or very soon after) the new loan closes. Some lenders even escrow (hold back at closing) funds until such repairs are completed. In addition, the lender may insist that the co-op establish a special “replacement reserve” to pay for major repairs that the engineer thinks may be needed during the term of the new loan.
An environmental assessment (if required) will determine whether the co-op’s property contains any hazardous substances (asbestos, lead paint, oil spills, etc.), whether any substances that were found pose a risk to co-op residents or adjoining properties, and (if so) what steps may be required to eliminate or reduce those risk(s).
Once a loan officer has evaluated all of this information, they usually summarize their findings in a report to their institution’s loan committee. The committee’s members typically evaluate each application in light of all of the others under consideration. If the co-op’s application presents an attractive lending opportunity with relatively low risk, it will be approved. If the co-op’s application is deemed to be higher risk, it may be approved with special conditions, rescheduled for further discussion, or rejected. If the application is approved, the loan officer will send out a commitment.
Since the commitment (or commitment letter) is the document that everyone has been waiting for, its arrival does justify a small celebration. However, much important work remains to be done. If the board has not discussed its planned refinancing with the co-op’s attorney before this point, they must do so now. Under no circumstances should a co-op return a loan commitment to a lender before reviewing it with their attorney. Every refinancing has myriad business and legal issues which must be handled carefully to avoid future problems for the co-op. The right time to address these issues is in the commitment (or even in the application, as some attorneys suggest) and the right person to address them is the co-op’s legal advisor.
While every commitment is a contract between lender and borrower that contains all of the terms of the proposed transaction, most commitments contain one or more conditions which must be satisfied within a reasonable time period before this contract is binding. If even one of these conditions is not met, your deal can fall through. Conditions in a commitment usually relate to documents or other information which must be supplied by the co-op’s attorney. For example, every loan requires a new title insurance policy to protect the lender’s security interest. Most lenders want a report from the Secretary of State certifying that the co-op is a corporation in “good standing.” They also request an “opinion letter” from the co-op’s attorney testifying that your co-op was properly formed and continues to operate as a bona fide cooperative. Most lenders require assurances that your property does not have any serious building code violations, mechanic’s liens, easements, or other encumbrances. As soon as all of this information has been reviewed by the lender’s attorney, a closing will be scheduled.
The closing is the final step in most refinancings. The closing is a meeting (attended by at least one co-op officer, the co-op’s attorney, the lender’s attorney, a title company representative, and others) at which the old loan (if any) is paid off and all of the documents describing the new loan are signed. It also is when all of the expenses of the refinancing are paid and the new loan proceeds are disbursed to the co-op.
A properly organized closing should take about two hours. However, if there are unresolved issues, a closing can last all day – or longer! Thorough preparation makes a big difference.
If you and your fellow board members plan carefully, stay focused, and involve all of your co-op’s professional advisors from the beginning, your refinancing should be completed within sixty days. It will be a very busy sixty days, but a very important and rewarding period as well. I wish you every success!
A: 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 not?
First, I don’t believe that anyone can predict, with any degree of certainty, what will happen over the next thirty years. Therefore, why would anyone want to lock their 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 preventative 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 2% 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 who current shareholders sell to. 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 twenty years of helping boards arrange new financing, I have closed just two 30-year loans…and each of those was due to 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-5% range for amounts under 500,000 to the low-4% 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.
A: Special assessments have been the traditional vehicle through which most condominiums have raised money for repairs and capital improvements. While relatively simple in concept, assessments have two drawbacks in practice. First, they usually take a fair amount of time to collect since most unit owners don’t have a lot of idle cash available. Second, most assessments place the entire financial burden of capital improvements on current unit owners instead of spreading it over the useful lives of those improvements.
Since 1997, though, condominiums and home owner associations have been able to borrow money for repairs and capital improvements. Borrowing tends to be a much more equitable way to fund such expenditures because the interest cost and principal repayment occurs over an extended period of time more in line with the likely lifespan of the building components being repaired or replaced. Initially, very few lenders were interested in this type of business, and those that were did not offer very attractive terms. Today, however, there is a reasonable selection of lenders with somewhat friendlier terms.
But don’t expect to find the 30-year self-liquidating loan at a rock-bottom interest rate that your neighbor’s co-op building just closed. More likely condo loan terms would be a 5-, 10-, or 15-year loan with amortization on a 10- or 15-year basis. These terms will result in a monthly payment that is higher than you might expect, but which will be much more affordable for the average unit owner than a lump-sum assessment. The shorter term and amortization schedule of condo loans are due to the absence of tangible collateral that could be mortgaged as security for the loan (as is typically the case for cooperative apartment buildings).
Not many condominium loans closed during the first few years after the law changed. It seemed that boards were unsure of the process or just accustomed to levying assessments. Over time, however, more and more condos applied for loans, especially as their buildings aged and required more extensive—and expensive—work. Today, most condominium boards are aware that they can borrow money for capital improvements and include that option in their funding discussions.
In almost every building, a certain percentage of unit owners still would prefer a lump-sum assessment to any increase in their monthly obligation. Most buildings also have a certain percentage of unit owners who could afford an increase in their monthly common charges but who would find it very difficult, if not financially impossible, to pay large assessments. In the past, these two factions usually battled it out until one or the other side prevailed.
The idea of funding a large capital improvement project by allowing some unit owners to pay their pro rata share of an assessment in one lump-sum (or several installments over a relatively short period of time) while other unit owners assumed financial responsibility for borrowing the remainder of the project’s cost has been considered by many boards over the last several years. However, this “split-funding” concept was just that—a concept—until a Long Island condominium I recently represented actually closed a loan on that basis.
The first step in any split-funding transaction is to calculate the total cost of the project being funded. The next step is to determine how many unit owners plan to pay their pro rata share of the total cost up front. Subtracting the second number from the first will tell you the net amount of loan you need. To that amount, I would recommend adding something extra to cover loan application fees and projected closing costs.
The mechanics of each split-funding transaction will vary from condo to condo, but the cleanest format for handling the monthly loan payments is to break the condo’s common charges into two tiers. Tier A covers the monthly operating expenses of the condominium and is invoiced to and paid by every unit owner according to their percentage ownership in the condominium association. Tier B covers the interest and principal payments on the condominium loan and is invoiced to and paid by only those unit owners who did not pay their pro rata share of the total project cost up front.
I would not recommend venturing into any split-funding transaction—or any significant financial transaction, for that matter—without consulting all of your professional advisors. There are quite a few issues to address in both the association and loan documents to ensure that each unit owner is treated fairly, and the condominium’s attorney will know how to handle those. Your accountant will provide much of the financial information required by the lender and also know the tax ramifications of such a transaction. Your managing agent will help determine the total cost of the project(s) being funded and, after the loan closes, they will program and administer the two billing tiers.
As I noted earlier, borrowing generally is a more equitable way of funding repairs and capital improvements for any building. Split-funding allows a condo board to both satisfy its financial needs and accommodate the individual financial preferences of its unit owners. I call it “win-win funding.” Good luck!
A: First, congratulations on being re-elected to the board! I wish you a productive tenure as treasurer. Second, I must admit that I had to search my files to find what your colleague was referring to: a 1999 article entitled “Minding Your "P"s. It talked about three critical elements of any successful underlying mortgage refinancing: planning, pricing, and processing.
Because refinancing an underlying mortgage is the most important financial decision that a board will ever make, it warrants careful and thorough planning. And effective planning requires the involvement of another “P” – the co-op’s professionals. Most co-ops have a managing agent, an attorney, and an accountant. Each of these professionals has knowledge and experience that should be ingredients in the board's planning. They will help you enter the market at the right time, borrow the right amount, and include the right terms and conditions in your loan documents. Whatever they charge you for their advice is money very well spent.
For example, your managing agent can help you assess your building's present physical condition, as well as likely future repairs. Your accountant can give you a realistic picture of your co-op’s past financial performance, its current fiscal health, and recommended changes going forward. Your attorney can review your existing loan documents for prepayment penalties and notice requirements which could complicate or prevent your refinancing. Together, these professionals can help you choose a loan structure and select a lender. They also can review your loan application, commitment letter, and new loan documents to ensure that everything meets the board’s objectives.
This "P" is the most misunderstood of the three. It is not, as most people assume, the interest rate offered by the lender. Your new loan's interest rate will be an important factor, but a low interest rate does not necessarily make a loan "good."
I usually suggest that people read “Pricing” as “Payment.” And I'm not just talking about the monthly payment. I mean the total payment. Of course, Payment includes your new loan’s monthly payment of principal and interest. However, it also includes any origination or commitment fees (“points”), tax and insurance escrows, operating or reserve accounts demanded by the lender, repair escrows, and penalties for violating other loan terms (e.g., late fees, prepayment penalties, etc.).
All of these elements comprise the “pricing” of a loan, and the board and its professional advisors must evaluate each of them in the context of the board’s goals and budget. Mishandling one or more of these other factors can have a much bigger impact on the co-op’s finances than shaving a few basis points off the interest rate (a “basis point” equals 1/100th of 1%).
Some boards are so happy to receive a commitment letter that includes the loan terms they requested that they almost forget the important work that remains to be done before their new loan can close. Many commitments contain a list of contingencies that must be cleared or documents that must be provided before the lender will schedule a closing. The co-op’s attorney can handle many of these items, but the board must stay focused on the items they must provide.
Other boards use their lender application letter or term sheet (and, sometimes, even a commitment letter) to “shop” for a lower interest rate with other lenders. All lenders hate this practice and, when they inevitably discover it, usually rescind their loan offer (and, in the case of a commitment letter, keep the co-op’s good faith deposit).
I have seen some boards argue a minor provision for so long that their commitment expires, costing them the “good deal” they had worked so hard to get. Some co-op attorneys forget to give their client’s existing lender the required pay-off notice, forcing the closing to be rescheduled (and, sometimes, incurring a hefty extension fee on the existing loan). Or someone misplaces the existing loan documents, thereby preventing an assignment and forcing the co-op to pay mortgage recording tax on the full amount of their new loan.
Boards need to remember the old sports saying that “it ain’t over ‘til it’s over.” In refinancing, no deal is done until it’s closed.
So, remember Planning, Pricing, and Processing – the three keys to refinancing success. Forget them at your peril (yet another “P”). Follow them and you can celebrate at the post-closing party (a few more “P”s)!
A: Both of these questions concern the role of debt. That role can be discussed in philosophical, financial, or physical terms. For example, to some people, debt is something to be avoided at all costs and, if incurred, paid off as quickly as possible. For others, it is a way to buy things with other people's money...so, the more , the merrier. This is the philosophical view on debt. It is rooted in a person's upbringing, cultural background, religious affiliation, and/or life experience. It tends to be more emotional than factual.
The financial approach compares the cost of the money being borrowed to the value or benefit derived from the loan. The concept of leverage employs this comparison of interest to return. So, a building might borrow money to replace decrepit wood-framed single-paned windows with new aluminum-framed double-glazed windows because the operating savings are expected to exceed the interest on the loan. While there may be an emotional component to this decision in terms of shareholder comfort, the final decision will be justified by numbers.
Sometimes, the need for money is unexpected (e.g., the boiler dies in the middle of February), urgent (e.g., brickwork falls from a facade or a plumbing riser bursts), or subject to significant escalation if the problem condition is not addressed in its entirety (e.g., serious roof leaks). In these instances, the physical realities of the situation drive the decision.
For me, debt is just a tool. It is neither good nor bad -- though its use may be one or the other. And, like any tool, it should be matched to the job at hand. A financial rule of thumb dictates that assets with relatively long lives should be financed with long-term debt. Therefore, a boiler or roof that might be expected to last ten or twenty years theoretically should be purchased with 10- or 20-year debt. However, the circumstances of the individual borrower, as well as the current market conditions, might call for a modified solution.
Unlike a cooperative, the legal and capital structure of a condominium does not include underlying mortgage debt. So, the issue of financing usually comes up in relation to capital improvements. For many years, condominiums funded virtually all repairs and capital improvements through unit owner assessments because existing law did not allow them to borrow for that purpose. Even after the law changed in 1997, many condominiums shied away from loans and continued to levy assessments. Over time, though, more condo boards are deciding to borrow, especially for very large projects that would require onerous assessments.
Since condo loans tend to be motivated by specific projects, it is easier to match loan maturity to estimated asset life. The market does restrict this a bit since the longest loan maturity currently available is 15 years, with many lenders offering only 5- and 10-year loans. A further complication is that virtually all condo loans are self-liquidating, i.e., they must be paid off over the respective loan term (either 5, 10, or 15 years). Nonetheless, paying for capital improvements through loans instead of assessments simplifies the funding process, spreads the financial burden of the capital improvement over a longer period of time, and has significant tax advantages for many unit owners.
Cooperatives, on the other hand, almost always have some amount of underlying debt. Further, that underlying debt rarely gets paid off, instead being refinanced again and again as a permanent part of the cooperative's capital structure. The need for repairs or improvements sometimes precipitates the refinancing of a cooperative's underlying mortgage, but other factors usually influence the final loan structure.
Cooperative apartment buildings tend to be older than their condominium counterparts and usually need major repairs every seven to twelve years. So, while a new roof might have an expected lifespan of 20 to 25 years, some other building component(s) may need repair or replacement before that time has elapsed. Also, because underlying mortgages are relatively large, overall budget issues and shareholder maintenance levels frequently dominate the discussion. Then, the current financial market may limit what is feasible. For example, present interest rates for 10-year mortgages are very favorable while those on 15- to 30-year loans are disproportionately high, making them unaffordable for many buildings.
So, getting back to the condominium trying to decide between assessment or loan, I will say that neither choice is right or wrong. However, I could make a fairly strong argument that a loan would be the better solution for all involved. Assessments are unpopular and, if repeated, can have a negative effect on unit values. They also can be troublesome to collect in a timely manner, which can delay the start or progress of needed work. Loans can be closed relatively quickly, have more useful tax advantages, and provide a more equitable distribution of the financial burden than an assessment. That's because current unit owners pay the entire assessment for an improvement that will last for 5, 10, 20, or more years. In contrast, a loan spreads the payment of interest and principal over that longer period and the changing unit owner population.
For the cooperative thinking about paying off its underlying mortgage with its reserve fund plus an assessment, I say, "fuggedaboutit!" Draining a reserve fund is never a good idea, but this purpose is especially imprudent. You might ask your treasurer to explain his plan for funding the next building system that needs repair or replacement. If you exhaust your reserve fund and pay off your existing loan, you just might find yourself struggling to collect an assessment in a hurry or secure a new loan from a lender who has little incentive to help you. Keeping your underlying mortgage at a reasonable level is a wise objective and maintaining an adequate reserve fund at all times the safe thing to do.
A: Any co-op contemplating the refinancing of its existing mortgage should first consult all of its professional advisors: managing agent, attorney, and accountant. While each of these advisors will provide important information to the board, the co-op’s accountant is the best person to compare the economic benefits of refinancing to the related costs. If you have not done so already, convene a meeting of all of your professionals to discuss whether refinancing is right for you. You also might invite a mortgage broker to this meeting to give you the latest market information.
A: You’ve asked a simple question that, unfortunately, doesn’t have a simple “yes” or “no” answer. When the Federal Reserve cuts interest rates, it is adjusting the discount rate or its target for the Federal Funds rate, or both. The discount rate is a fixed interest rate that the Fed charges its member banks for short-term loans. The Federal Funds rate is an interest rate, determined by supply and demand in the marketplace, that banks charge each other for overnight loans.
Whenever the Fed adjusts either of these key rates, the effects appear almost simultaneously in other short-term interest rates. For example, most money center banks will change their “prime” lending rate, usually by the same increment as the Fed change. The rates on U. S. Treasury securities with maturities of two years or less typically trade in the same direction as the Fed’s adjustment. Many consumers will notice a similar change in the interest rate on their credit card statements, as well as a parallel adjustment in the interest rate paid on their savings and money market accounts. So, the “yes” part of my answer is that most banks and other financial institutions do raise or lower their interest rates whenever the Federal Reserve makes a change.
However, Federal Reserve policy is just one of the many factors that influence mortgage and other longer-term interest rates. First, most mortgage lenders set the interest rate on a new loan by adding a margin, or “spread,” to some market index. Lenders use a variety of indexes, depending on the type of loan that they are making. Many commercial mortgage lenders, including most co-op underlying mortgage lenders, use the rate on 10-year U. S. Treasury securities. These securities are favored as safe investments by many institutional investors, and their rates fluctuate daily in response to supply and demand in a broad, active market. The 10-year Treasury rate is reported in the financial pages of most major newspapers and on many financial websites like cnnmoney.com or bloomberg.com.
The rate on 10-year Treasuries does not move in lock-step with changes that the Fed might make in short-term interest rates. As fixed-income investments, Treasuries often are used as alternatives to equity investments like stocks. And, because the rate on a fixed-income instrument varies inversely with its price, a “good” day for stocks often means a “bad” day for Treasuries (i.e., lower prices and higher rates).
In addition, since Treasury securities are backed by the full faith and credit of the U. S. government, they are viewed world-wide as relatively riskless “safe haven” investments in times of political and/or economic upheaval. For example, an increase in Mid-East tensions could generate a surge in Treasury investments. That increase in demand will drive up Treasury prices and reduce their rates…totally independent of any Fed action.
Alternatively, let’s assume that the Fed cuts short-term interest rates by a relatively aggressive half-point to prop up our sagging economy. If the broader market views that change as doing more to ignite inflation than to spur economic activity, Treasury rates actually might trade higher! So, the market’s perceptions of Fed actions sometimes have a greater, possibly counter, effect than the actions themselves.
A second determinant of mortgage rates is the spread that a lender adds to their chosen index when pricing a loan. Many co-op board members are surprised to learn that spreads also trade daily, just like the 10-year Treasury. Loan spreads are “built up” by adding together two principal components. The first component is the so-called “Wall Street spread,” or the return demanded by secondary market investors who buy loans from lenders after closing. Even if lenders don’t plan to sell their loans, they still underwrite virtually all of them to the standards required by the secondary market. The Wall Street spread reflects general money market conditions, as well as investor perceptions of…or uncertainty regarding…future market conditions. Whenever there is turmoil in the financial markets, this component of the loan spread is where it shows up. To put this in perspective, as the wider effects of the sub-prime mortgage mess became more apparent, the Wall Street spread grew by more than 100 basis points!
The other piece of the loan spread is the “lender spread,” or the fee charged by the lender for servicing the new loan during its term (i.e., collecting the monthly payments and handling all of the administrative issues related to the loan) plus their profit. A lender may choose to decrease either or both of these amounts for competitive reasons, or they might decide to increase either or both of them because of uncertain market conditions or profit goals.
After many years of relative calm and growing prosperity, world financial markets are now in disarray due to the sub-prime mortgage debacle. What initially was thought to be a problem confined to a small segment of the single-family home mortgage market has grown to a world-wide financial crisis affecting virtually every financial transaction in some way. The effect within the co-op underlying mortgage market has been a dramatic increase in loan spreads, averaging almost 10 basis points per month over the last year. Fortunately, the 10-year Treasury has fallen by almost the same amount over that period, so the net effect on underlying mortgage rates has been minimal. However, since the decline in Treasury rates has received lots of coverage in the press, while the rise in spreads has not, the general public feels that lenders must be doing something “fishy.” For the most part, lenders are a pretty honest and hard-working lot. The people who smell are the unqualified borrowers who lied on their loan applications, the lenders who looked the other way while closing sub-prime loans to unqualified borrowers, the rating agencies who didn’t do their homework, and the greedy investment bankers who misrepresented all of that junk while selling it to institutional investors. The good news is that underlying mortgage rates are pretty good, despite this mess. So, go do your deal!
A: For most co-ops, this is not quite the “chicken or egg” question that it initially seems to be. The typical cooperative usually can support enough new debt to cover almost any major repair. In many cases, the building’s maintenance must go up, which could pose a hardship for certain shareholders. However, the required increase rarely is enough to cause problems for the cooperative as a whole. While I haven’t seen your co-op’s financial statements, other things you’ve told me lead me to believe that your building can carry the planned amount of new debt.
It is true that certain segments of the financial markets have been affected quite severely by the problems reported in newspapers and on television programs. Fortunately, the co-op underlying mortgage segment has been relatively unscathed by those problems. Consequently, the fears of your fellow board members about your building’s ability to borrow are most likely unwarranted. That said, your insistence on signed contracts for all work before entering the mortgage market is overkill. A range of bids from several legitimate contractors should be sufficient to help you estimate the likely cost of each planned project. I then would add a contingency (5% to 20%, depending on the complexity of the work) to each project’s estimate. The resulting total will be close enough for most lenders. Having that number, though, does not mean that you are ready to start searching for a new loan.
Refinancing an underlying mortgage is perhaps the most important decision that a board will make during its tenure. It will affect not only the monthly maintenance, but also the market value of every shareholder’s apartment. Therefore, it is essential that you broaden your focus beyond the work you have planned now to the overall physical and financial health of your cooperative. A successful refinancing puts a cooperative on a sound financial footing that ensures its long-term viability. Attaining that success requires careful planning, thorough preparation, and professional guidance. That’s why I recommend that every board involve all of their co-op’s advisors in this critical process. Don’t have a full team of professional advisors (managing agent, accountant, and attorney)? Now is the time to hire them.
For example, in addition to streamlining your building’s day-to-day operations, your managing agent can help you develop plans and specifications for each project, recommend reputable contractors, help check that all bids are complete, assist in negotiating final prices, coordinate schedules for each trade, and assure that all required approvals and permits have been secured. Your accountant will keep your books, but they also can assemble all of the financial and tax records that any lender will require, help you prepare a budget reflecting the planned new loan, estimate the amount of any prepayment penalty on your existing loan, and assist in evaluating various new loan options. Your attorney will help negotiate contracts for each project, check your insurance coverages, review your existing loan documents to make sure that they allow you to refinance, check the public records for building violations and outstanding liens, evaluate loan offers and review loan applications, and (of course) represent you at the closing. And these are just some of the many important things that a good team of professional advisors will do for you. By the way, the time to get all of your professional advisors involved is now, at the very start of the refinancing process. The benefit of their input at the beginning, middle, and end of this process is worth way more than whatever they will charge you.
You might have noticed that I did not include a mortgage broker among the professionals that I recommend you hire. While I believe that any loan transaction can be enhanced through the efforts of a seasoned mortgage broker, loans close every day without such assistance. Whether those loans have the lowest interest rates and the best available terms is subject to debate. However, the more troubled or complex a borrower’s situation, or the more stressed or volatile the market, the greater the value of a professional who deals with such issues every single day. A skilled mortgage broker knows exactly whom to call and how to present your situation in the very best light.
A: In broad terms, yield maintenance is a process for protecting lenders from losing interest when loans are paid off before their maturity date. A loan is a contract under which the lender agrees to provide funding for a period of time and a borrower agrees to pay interest (and sometimes a little bit of principal) during that period and then pay the remaining balance back to the lender at the end of the period. The lender counts on receiving the specified amount of interest over the specified loan term as their return on their “investment” in the loan.
The contract protects the borrower by preventing the lender from calling the loan before the maturity date, even if interest rates in the market go up and the lender could make more money by cancelling existing loans and making new ones at current rates. However, the contract does not give the lender similar protection by preventing the borrower from paying the loan off early. Instead, the prepayment provisions of the contract compensate the lender for such early pay-offs. So, in the overall scheme of things, borrowers get the better end of the deal.
In the “good old days,” lenders just charged a set penalty based on when the borrower prepaid (usually a declining percentage of the outstanding balance at the time of prepayment). Eventually (about 10 years ago), lenders realized that those set amounts did not fully compensate them for the cost of reinvesting the prepaid loan amounts…especially in times of declining interest rates. So, most lenders changed to a formula that came closer to recognizing the true time-value of money in the market environment prevalent when the prepayment occurred. In the overall scheme of things, this was more equitable toward lenders. As I mentioned earlier, yield maintenance has become the standard for virtually all commercial real estate loans…not just co-op underlying mortgage loans. I do not see this changing in my lifetime.
The calculation of any yield maintenance prepayment penalty is an ever-changing exercise because most of the determinants change daily in response to market forces. However, like all penalties, yield maintenance tends to decline over time…the closer the loan is to maturity, the smaller the penalty becomes. As an example, let’s take a loan of $3,750,000 for 10 years at 2.30% over the 10-year treasury with 40-year amortization. If we assume that all interest rates remain exactly where they are now over the next 10 years, then the prepayment penalty would be about:
$667,000 after 3 years…
$530,000 after 5 years…and
$273,000 after 8 years.
You will note that all of these numbers are quite large…but they could be even larger, or much smaller, if interest rates moved in the right combination of ways. Remember, the penalty is based on the present value of the interest that the lender will lose because the loan gets prepaid. That number depends on the timing of the prepayment, the amount prepaid, and the market rate for a treasury security with a maturity equal to the remaining term of the loan when it gets prepaid. Therefore, predicting prepayment penalties is, at best, a guessing game. That’s why no one makes new loan decisions based on the possible prepayment penalty. Instead, most borrowers forecast their future cash needs and set a loan amount with enough of a cushion such that the potential need to prepay sometime before maturity due to lack of cash is minimized.
In short, the goal is not to find a loan with a small or no prepayment penalty…so you can refinance at little cost when you run out of money before you run out of loan term. The goal is to borrow enough money in the first place such that the likelihood of running out of money during the loan term is minimized.
A: You’d have all the options you thought you had – plus a few more – were it not for your prepayment penalty. Unfortunately, virtually all underlying mortgages have one. The less onerous penalties are based on a flat percentage of your outstanding balance, and that percentage declines over the life of your loan. For example, on a 10-year loan, the penalty could be 5% during the first two years, 4% during the next two years, then 3%, 2%, and 1% for each succeeding two-year period. A few lenders still offer this form of prepayment penalty.
Most lenders, though, have switched to your form of penalty. A “yield maintenance” prepayment penalty does just what the words say; namely, it maintains the yield of the loan for the lender. When a lender makes a loan, it signs a contract to provide the borrower with a certain amount of money for a set period of time in exchange for a predetermined amount of interest. If a borrower breaks this contract by paying off their loan before the maturity date, the lender must re-invest the proceeds by making another loan to a different borrower at the then-prevailing rate.
If rates have fallen in the meantime, the lender might earn less interest on this new loan than it would have on the old loan. Rather than take that risk, many lenders impose prepayment penalties that require the borrower to pay them the present value of the interest that they would have earned had the borrower not prepaid. In other words, the penalty “maintains” the lender’s “yield” from each loan whenever a borrower chooses to break the loan contract by prepaying. This is the same principle that bankers use to justify penalties when investors cash certificates of deposit (CDs) before their maturity dates.
Because of the way they are calculated, yield maintenance penalties usually outweigh the economic benefit of refinancing. However, that is not always the case. At certain times in the interest rate cycle (like the past year or so), the savings from refinancing are so great that they recoup both the closing costs of refinancing plus very substantial prepayment penalties within just a few years. That’s why I always recommend that board members “run the numbers” before they reject the idea of paying a prepayment penalty.
Depending on what your numbers show, the best solution for your situation might still be a refinancing. If not, there are other options to consider. You might look for a credit line or a second mortgage. Credit lines operate much like an overdraft privilege on your personal checking account. A bank agrees to lend your cooperative up to a certain maximum amount, to be drawn down as you need the funds (usually in increments of $5,000 or $10,000). You pay interest monthly, at a floating rate (say, prime plus 1% to 2%), on whatever balance was outstanding during the previous month. This arrangement usually lasts for a limited period of five or ten years, after which the outstanding balance must be repaid.
Second mortgages are very similar to your first mortgage, though usually smaller. They typically have a fixed interest rate and the same maturity date as your first mortgage. Second mortgages are somewhat harder to find, but I tend to recommend them over credit lines – especially for capital improvements. Credit lines are fine for emergency needs, but permanent additions to your building’s physical plant should be funded with fixed-rate debt. It is imprudent to expose your cooperative’s budget to variable-rate debt on a regular or long-term basis.
Of course, there always is the old stand-by solution of an assessment. Many boards find assessments to be politically unpopular, while others prefer the “pay as you go” nature of assessments. On one level, I agree with their logic. However, assessments deprive shareholders of the on-going tax benefit generated by loan interest. They also have been shown to depress the market value of apartments under certain circumstances. So, assessments should be considered very carefully.
You also could raise maintenance. However, aside from the negative reaction that this action might cause, you’ll need either a very large increase or a very long time to raise the $400,000 you need to pay for planned capital improvements. Another alternative would be to borrow the money from one or more well-heeled shareholders. They might be delighted to withdraw their money from a money market fund paying just 3% and lend it to the cooperative at, say, 8%. Or you could approach another cooperative that has a large reserve fund and borrow money from them.
A final (tongue-in-cheek) suggestion would be to take whatever money you have in your reserve fund and buy lots of lottery tickets. If you win, you’ll be a hero. If not…well, let’s just say that you’ll be living in a different kind of “apartment.”
A: Refinancing an underlying mortgage is much more complicated than refinancing a house or a co-op apartment. Despite the residential nature of your building, your underlying mortgage is a commercial loan. As such, it is subject to all of the regulations and customs of the commercial market.
In most cases, lenders are required to support their decision to lend with detailed reports prepared by independent third parties like appraisers, engineers, and environmental experts. Commercial lenders also demand new title insurance, updated surveys, and searches of the public records for liens, lawsuits, building violations, unpaid taxes, or other problems. As you might guess, lenders charge the cost of all this work to their borrowers.
Lastly, the underlying loan documents themselves are much more complicated than those used for personal loans. That means more legal work on both sides of the transaction and, of course, the borrower pays for that as well. For most refinancings, boards should estimate three to four percent of the loan amount (with a minimum of $10,000) for total closing costs. At that level of expense, it really pays to do things right.
A: For most co-ops, the risk of making a serious mistake far outweighs the potential savings. Today’s financial markets are much too volatile, and lender offerings far too numerous, and the refinancing process way too complex for any lay person to keep up. While you might save a brokerage commission, and perhaps some legal or other professional fees, you rarely will uncover the best deal. It’s also likely that you will overlook key loan provisions that could haunt you at some point down the road.
Unless your board has extensive mortgage market experience, don’t go it alone. Refinancing is the most important economic decision that any board can make. It will affect not only your monthly maintenance but also the value of every shareholder’s apartment. With so much at stake, it truly pays to get the best advice money can buy. Call all of your co-op’s professional advisors…your managing agent, attorney, and accountant…as well as a skilled mortgage broker…and keep them involved from start to finish!
A: Depending on your situation, your existing lender may or may not be the best choice. If you refinance with your existing lender, you might save some fees or avoid having to pay for certain reports to be updated or redone. On the other hand, a different lender might have a much lower interest rate or be able to structure a loan that is more suited to your current needs. To find the best deal, you have to canvass the market.
A: As a general rule, you should enter the market no earlier than 18 months, and no later than 6 months, before the maturity of your current loan. However, if your existing loan has a very high interest rate, or you need extra money now for major repairs, or you have some other special situation, refinancing before your current loan comes due might be the right choice for you. The only way to know for sure is to crunch the numbers.
A: The old rule of thumb was that a difference of 2% between your loan’s interest rate and current market rates was enough to justify a refinancing. But today’s loan structures and yield maintenance prepayment penalties are so complex, and the refinancing process itself is so expensive and time-consuming, that such general rules are obsolete. For some situations, a 1% difference is sufficient to make refinancing worthwhile. For others, a 3% spread isn’t enough. So, it really pays to “do the numbers!”
A: Refinancing your underlying mortgage is not necessarily the best way to raise the money you need…and it certainly isn’t the cheapest way to do it. Before incurring the cost of refinancing, you first should exhaust all of the other options like an increase in maintenance, a special assessment, the sale or lease of excess building property or air rights, loans from wealthy shareholders, contractor credit, and other sources of financing. However, if none of those options provides what you need, then refinancing may be the right choice for you.
A: All lenders limit the amount you can borrow to some percentage of your building’s total value, usually no more than 75%. This limit is most often expressed as a loan-to-value ratio, or LTV. And the value we’re talking about is not the most recent apartment sales price multiplied by the number of units in your building. Rather, it is the value of your building if it were converted back into a rental. Your LTV also plays a big role in the pricing of your new loan. In most cases, the lower your LTV, the lower your interest rate. So, never borrow more than you need.
A: It depends. Many accountants recommend that all of their co-op clients get a credit line to serve as a source of emergency funds. Conceptually, that’s a great idea…as long as everyone remembers that credit lines are short-term variable-rate debt.
Unfortunately, many boards use their credit lines to subsidize daily operations because they don’t want to take the politically unpopular step of raising maintenance to keep pace with inflation. Pretty soon, these boards find that a major portion of their budget is out of control due to rising interest rates. Credit lines are not substitutes for prudent budgeting and regular maintenance increases.
Other boards use their credit lines to finance major capital improvements like new boilers, windows, and roofs. This practice violates a major rule of finance that long-term fixed assets should be financed with long-term fixed-rate money. A second mortgage is a better choice for most capital improvements, while credit lines are best used for true emergencies.
A: You find a good mortgage broker the same way you find a good managing agent, lawyer, or accountant. You check the internet, read trade publications like NY Habitat and The Cooperator, ask friends in other buildings, and get recommendations from your other professional advisors. Then interview as many brokers as it takes to find a “good fit” with your board and, finally, hire just one. Lenders always wonder what’s wrong with co-ops that need two or more mortgage brokers to get them a loan. So, don’t give your building a negative reputation. Never, ever, hire more than one mortgage broker.
A: These days, virtually all underlying mortgages have some form of prepayment penalty. The less onerous penalties are based on a flat percentage of your outstanding balance, and that percentage declines over the life of your loan.
Unfortunately, most lenders have switched to “yield maintenance” which, as the words imply, maintains the yield of the loan for the lender. The formulas used to calculate yield maintenance prepayment penalties are rather complex, and they usually result in very large numbers. That’s because the formulas give the lender the present value of all of the interest they would have received had the borrower not prepaid.
Remember, though, I said “usually.” Sometimes, the savings from a new loan with a much lower interest rate can overcome even a yield maintenance prepayment penalty. So, again, it pays to “do the numbers.”
A: As a general rule, I strongly recommend that boards consult all of their professional advisors before making any important decision…especially one as important as the refinancing of an underlying mortgage. And, in most cases, it makes sense to follow your advisors’ advice. However, understanding the principles behind their recommendations sometimes makes them easier to follow, and such understanding also helps you make a reasoned decision when all of your advisors don’t agree.
Refinancing an underlying mortgage is one of the most important decisions that any board can make. It will affect not only the monthly maintenance of every shareholder, but also the market value of each of their apartments. So, the structure of your new loan is critical to a successful refinancing.
Apparently, your accountant feels that your new loan should include at least some amortization. Amortization is the monthly repayment of a small portion of the outstanding loan principal in addition to the monthly interest that is due. Even a minimal amount of amortization guarantees that you will repay enough of your loan by its maturity date to cover the closing costs of your next refinancing. That assures that the debt on your building does not grow over time solely due to refinancing costs. This could be one of the reasons for your accountant’s opinion.
Another reason could be that interest-only loans saddle future shareholders with the entire burden of an ever-increasing amount of debt. Some board members argue that this growth in debt is irrelevant since most underlying mortgages are never paid off but, rather, are just rolled over indefinitely. While most co-op underlying loans are rolled over, increasing debt loads eventually will force every board to increase maintenance and/or cut services by more than would have been necessary had amortization been included in each monthly payment.
Other board members suggest that increases in apartment sales prices make their building more valuable and, hence, able to carry more debt. There is some truth to that idea, but it should be remembered that (recent trends notwithstanding) market values do not always go up. The size of your underlying mortgage as a percentage of your building’s overall value will affect the pricing of any new debt. The lower the percentage (or “LTV” ratio), the better the interest rate on your new loan.
From a lender’s viewpoint, the value of your building is not the average sales price multiplied by the number of units in your building. Instead, it’s the somewhat hypothetical value of your building if it were converted into a rental. So, amortization acts like an insurance policy against getting priced out of the most favorable sectors of the mortgage market.
There also is a philosophical “fairness” argument in favor of amortization. Interest-only loans afford current shareholders all of the benefits of the new funds, as well as the lowest possible monthly payment. They get to ride in the new elevators, sleep under the new roof, and look out the new windows without having to pay their pro rata share of those improvements through monthly amortization. Moreover, if they sell their unit before the new loan matures, they receive an added bonus because their sales price will reflect the perceived value of all of the improvements even though they didn’t pay for any of them. That “privilege” goes to future shareholders.
A more equitable arrangement would be to include amortization as part of every new loan so that every shareholder pays back some of the cost of each improvement. To carry this point even further, I could make a theoretical case for matching the amortization of every new loan to the average useful life of the improvements being funded by that loan. To reach that academic standard, however, would require perfect data regarding useful lives and some pretty complex calculations. The “plain vanilla” amortization offered by most lenders is a sufficient approximation.
Having said all of the above, there are situations in which an interest-only loan is the appropriate…and maybe only…solution. For example, at the time of their conversion, some buildings got stuck by their sponsor with very large loans at below-market interest rates. Replacing those loans at current market rates could place a substantial burden on shareholders, and amortization would make that burden even harder to bear. In these situations, transitioning to an amortizing loan over several refinancings may be the only feasible choice.
Alternatively, a sponsor or previous board may have postponed repairs and building upkeep for many years to avoid a maintenance increase. When the repairs become critical, the current board may be forced to borrow a lot more money. Again, an interest-only loan may be the only affordable way to get the job done without creating hardship for many shareholders.
During times of very high interest rates, some boards decide to replace their maturing loans with shorter-term (3-, 5-, or 7-year) interest-only mortgages, planning to refinance them with traditional longer-term amortizing loans once interest rates decline. This strategy incurs a double dose of closing costs but might result in lower total expenses over the full time frame.
It also may be possible to structure a combination approach. Some lenders offer loans that are interest-only during a certain introductory period after which amortization kicks in for the remainder of the loan term. This structure might allow boards to obtain the additional funds that they need now at a lower monthly payment, and then gradually raise maintenance over several years to the level necessary to cover monthly amortization.
I apologize for such a long-winded response to your question. My short answer would be to discuss your situation with all of your professional advisors (your managing agent, accountant, and attorney) and, barring some special consideration, follow your accountant’s advice.