The Hands-Off Investor by Brian Burke

Author:Brian Burke
Language: eng
Format: epub
Publisher: BiggerPockets Publishing
Published: 2020-01-14T16:00:00+00:00

The new buyer is now assuming a loan that is only 60 percent of the purchase price. While the first owner put 25 percent down, the second owner is putting 40 percent down. In order for the second buyer to get a similar return on their invested dollar, they would have to buy at a below-market price, which is a problem for the seller.

Assumption/Supplemental Combination

A solution here could be an assumption with a supplemental, where the supplemental brings the total debt up to 75 percent of the purchase price. This solves the problem we just discussed but introduces another: The blended interest rate is higher because of the higher-rate supplemental loan. So again, the buyer will be seeking to purchase the property for a lower price to offset the higher interest rate.

The second problem introduced by the assumption sale is that the new buyer will also be looking at the yield maintenance risk on the loan. If their business plan is to sell prior to the loan maturing, they’ll have to pay the yield maintenance due at that time. This could cause the buyer to subtract that expected yield maintenance premium from the purchase price, again resulting in a lower price to the seller.

So which is better, fixed or floating? This comes down to using the right tool for the job. Debt is a tool, and as we’ve just seen, the wrong tool can cause a complete failure of the business plan, turning a would-be profit into a break-even or even a loss. Using long-term fixed-rate financing with yield maintenance penalties might not be the right tool for a short-term business plan, just as using short-term financing for a long-term plan introduces loan maturity risk. Use the right debt for the right plan.

The way I see it, floating rate exposes you to the risk of interest rate movement. Fixed rate exposes you to the risk of yield maintenance penalties or defeasance costs.

On the other hand, floating-rate loans give the sponsor flexibility to react to the market and sell whenever the timing is right, without the gun to their head of a looming yield maintenance penalty influencing their decision. For some business plans, this might not be a factor. In any event, runaway interest rates can be mitigated by purchasing an interest rate cap. An interest rate cap is generally set a couple of percentage points above the rate at the time the loan is originated, giving some disaster insurance if rates go on a steep climb. Rate caps aren’t all that expensive, at least not when compared to yield maintenance. A three-year cap is generally available for somewhere between a quarter and half a percent of the loan amount.

Common Loan Terms

In addition to those related to interest rates, there are other loan terms you should pay attention to. Let’s cover a few.

• Loan term. This is the period of time before the loan matures. A ten-year term means that the loan will be due in full at the end of the tenth year.

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