Investment in commercial real estate properties can be highly advantageous. But only some have got the required funding available to them. This is why financing options are available that help the person use the available opportunity the most and get the best for their investment.
For instance, an interest-only loan is an excellent option for commercial real estate investments. After all, it only comes with a specific interest for a short time.
Make sure that you research well about the options available to you. It would be best to see which lender will provide you with the best interest rate for the same. It will help you get the right deal for the investment.
If you have been in the commercial real estate industry, you already know about the interest-only financing option. It is when you only have to pay interest payments but no principal payments on the loan.
This sounds good on paper, but many people must be made aware of the same. If you, too, are worried, then the details here will help you understand things better.
What is an interest-only loan?
This type of loan is the one where the borrower only needs to pay the interest but only for a specified amount of time. The period will typically be laid out in the loan agreement.
Once the interest-only period is finished, the loan will become a typical amortizing loan. Here the borrower will continue to pay the loan principal and the interest with each payment.
Such a type of loan can be extremely beneficial when choosing to invest in commercial real estate properties.
One can quickly secure an interest-only commercial real estate loan at earning interest equal to the principal loan balance. But still, there can be a lot of associated aspects. Thus, it will benefit you to understand things better before you decide on getting the loan.
Using the interest-only loan
The interest-only period’s significant impact on real estate is that it can significantly increase the project’s cash flow and the expected returns.
As a result, the cash flow will increase when you will not be paying the principal payment on the interest every month. But it is best to look at how the numbers work and their impact on your real estate deal.
For instance, let’s consider an example to calculate the total interest-only payment on a $7 million at 4.5% interest that will be amortized for 30 years. With this, you must pay $425,616 per year in debt service on loan.
However, if you assume the loan payment is an interest-only loan, then the annual debt will come to around $315000 per year. This will produce $110616 additional cash flow annually for the interest-only period.
The difference here is clear, and the cash flow must be substantial. But the point where it gets more impactful is when you take a look at the changes in the cash-on-cash return in the same scenario.
Let’s consider a loan of $7 million on a $10 million acquisition. This means you will have to invest $3 million in equity to close the deal.
Herein assuming a $3 million equity investment will result in $110616 of additional annual cash flow in the interest-only scenario. This will represent a 3.7% increase in cash-on-cash returns every year. This will be a massive spike which will help get better returns for the investor.
Interest-only loans will reduce the total profit.
There can be a lower interest on loan period on the real estate even when there is a higher cash-on-cash yield or cash flow. This happens when the period can decrease the total whole-dollar profit on the deal because the loan balance will not be paid down at once.
In addition, the actual interest cost will be higher during the interest-only period as the interest will be calculated based on the outstanding loan balance. This is when you will know the right time to consider such loan options for your business. After all, it can significantly impact your total profit.
For instance, a $1,000,000 loan at an interest rate of 5.0% will amortize over 25 years. Thus, he was the total interest payment for the first few years will come down to $49532.
However, if the interest-only scenario is calculated, the total amount will be $50000. This makes a $468 difference which might not seem like much in one year, but when the number starts getting bigger, it will explode over a more extended period. This is where things will get interesting.
Interest-only loans can increase the IRR.
A great thing that an interest-only period loan can do is increase the IRR, even though the total profit on the deal reduces significantly.
But the interest-only period will bring additional cash flow during the holding period, and with this, the IRR will bring in the value of the money function. This is because the cash flow received earlier in the whole period will be worth more than the same that you received in the entire period for calculation purposes.
When to consider an interest-only loan?
If you hope to make the most of the interest-only loan, you must understand the circumstances where it will work the best for your case.
- In case you are interested in looking primarily at maximizing the cash flow or the cash on the cash returns, then choosing interest only for a period within the loan will be a great way to make this happen.
- The interest-only periods can provide a significant boost in the cash flow during times when the operating cash flow will be tight. This includes periods of releasing efforts to improve the property, heavy renovations, or stabilizing the deal.
- In case you plan on spending a more significant amount of capital in the first few years of the ownership, then choosing the interest-only loan will be the best. It will also be good for you when there is a significant drop in occupancy which can result in expiring leases. During such a time, the interest-only loan can be quite helpful in preserving investor distribution during tough times.
- If you are a GP-raising equity firm from a third-party investor, you must make decisions based on exceeding specific IRR targets. This will maximize the interest-only period on the loan, which will generally be in your best interest. In addition, it will allow you to choose the cash flow for the whole period. Thus, it will sometimes bring the IRR by 50 to 100 basis points or more.
There can be certain situations when you need to think twice about interest-only loans. In case you are an investor holding the property for long-term wealth accumulation and are not concerned about the cash flow.
Avoiding the whole dollar profit perspective without the interest-only period will be better. You must know that all your real estate decisions will be based entirely on your personal objective.
But the interest-only period can only be a helpful tool in your back pocket when choosing to juice the cash and cash on the IRR values.
You must understand the market condition when making the decision. Therefore, analysis and research about all the essentials will be helpful for you to see what will work best for you.
Benefits and risks of an interest-only loan
A major benefit one can enjoy with such types of loans is the cash flow in the short term. It will be helpful if you want to reinvest the cash into property improvement or acquisition.
Additionally, when you only pay the interest on a loan, the monthly payment will be lower than when you pay both principal and the good. This will help free up the additional cash flow every month.
No doubt there is risk associated with all types of loans. But with an interest-only loan, a significant risk is that your monthly payment can increase significantly at the end of the interest when you must start paying both goods and the principal.
Besides, you will be underwater on a loan if the property value decreases. You will be paying more than the property is worth. So talking to a well-qualified broker will be helpful to know the options.
If you plan to get an interest-only loan, consider connecting with Private Capital Investors to understand the options. They have called certified professionals who understand the industry.
Irrespective of your requirement, the experts will make things comfortable. They will help you understand the options and finish the deal immediately. You can rely on their experts to know better about the situation and get a good loan option at a fair interest rate.