3 ms·

I think this just reflects a sales strategy. Back when it didn't look like commercial was risky, you could win business by advertising a low monthly payment.

I think this just reflects a sales strategy. Back when it didn't look like commercial was risky, you could win business by advertising a low monthly payment. Interest-only works for commercial because the building is (hopefully) making money, so some of that can be set aside to handle the last payment. That doesn't work for residential, because single-family homes don't usually make money, so residential homebuyers don't typically have ~$200,000-$2,000,000 in cash at the end of the 30 year period. But if that was feasible, you would see some loan officers trying to win business through offering interest-only mortgages with a balloon payment. As for why underwriting didn't catch this? Underwriting is a lot like actuaries, they've got a bias towards recent population-level data. So for the last 30 years the rates of commercial default have been predictable, and it's tough to push back to execs on the risk. You're claiming that a potential wide-scale change in the way the U.S. works should impact sales strategy today, and before Covid that risk was very abstract. Very few execs would side with their underwriters over their sales team, and there's been subtle pressure on underwriters to price commercial real estate as though systemic risk isn't real.

creer 3y ago
The building operation pays the interest (and upkeep). The last payment is the whole loan - it comes from a refinancing: rolling over the whole thing from one loan to the next one - or from a sale (same thing actually: rolling over from one property to another). The issue is that since the last refinancing, interest rates changed.
- jimberlage 3y ago
  It usually comes from a refinancing, but doesn’t have to! Any land productive enough to recoup its development costs before the balloon payment is due is a good fit for these loans. Refinancing was so common because interest rates historically went down, but hopefully some of the underwriting data prior to this last low interest rate environment would contain some bad loans caused by the lendee not saving enough for the balloon payment. That is hopefully a part of the underwriting model, unless they have a truly short lookback period.
  - creer 3y ago
    I don't know where you are. Let us know how it works there. (1) In the US, most commercial real estate loans are short term. Three years or something? (looks like 3-10, longer than I thought) (Perhaps construction loans are longer). Far too short for the owner to repay the loan even if they wanted to. (2) And there is little reason for the real estate investor to repay the principal (except through sale or refinancing) - that would be leaving money on the table. You don't need to repay the principal. As long as you are in good standing you can roll over the loan into the next one - refinance. You can stay leveraged and use any profits to live on and buy more property (Until - not infrequently - things go bust and the bank owns the building.) A different case might be a condo development: Private investment (rolled over from selling another property and repaying THAT loan) and loans to buy the land, loans to build, sell 60% of the units, - and there might be enough to repay most of the loan.
    - jimberlage 3y ago
      I don’t think this is the typical borrower profile now, but balloon loans are historically for people who have most of the cash needed for development (or who have all the cash needed and think that they can get a 10% return while their interest rate is 6% over the life of the loan.) In that case, since you already have most of the capital lying around, a balloon payment lets you use other cash but you’re not worried about a large payment. Seems like a lot of commercial real estate is structured as a balloon loan to people who may not be able to make the lump sum payment, which is probably where the underwriting failure lies. Refinancing is a tool a savvy borrower can use as rates go down, but it’s not a strict expectation that you do that if you get a balloon loan, even on short term loans.
rufus_foreman 3y ago
>> That doesn't work for residential, because single-family homes don't usually make money, so residential homebuyers don't typically have ~$200,000-$2,000,000 in cash at the end of the 30 year period Before the US government got involved, the typical real estate loan was a 5 or 10 year balloon loan that had to be refinanced at the end of the loan period. Large part of them were interest only. So that's exactly the way it used to work. That blew up during the Great Depression. Then the government stepped in and started subsidizing loans which is where we're at now, the mortgage market in the US is very different than in say Canada or Europe.

creer 3y ago

The building operation pays the interest (and upkeep). The last payment is the whole loan - it comes from a refinancing: rolling over the whole thing from one loan to the next one - or from a sale (same thing actually: rolling over from one property to another). The issue is that since the last refinancing, interest rates changed.

jimberlage 3y ago
It usually comes from a refinancing, but doesn’t have to! Any land productive enough to recoup its development costs before the balloon payment is due is a good fit for these loans. Refinancing was so common because interest rates historically went down, but hopefully some of the underwriting data prior to this last low interest rate environment would contain some bad loans caused by the lendee not saving enough for the balloon payment. That is hopefully a part of the underwriting model, unless they have a truly short lookback period.
- creer 3y ago
  I don't know where you are. Let us know how it works there. (1) In the US, most commercial real estate loans are short term. Three years or something? (looks like 3-10, longer than I thought) (Perhaps construction loans are longer). Far too short for the owner to repay the loan even if they wanted to. (2) And there is little reason for the real estate investor to repay the principal (except through sale or refinancing) - that would be leaving money on the table. You don't need to repay the principal. As long as you are in good standing you can roll over the loan into the next one - refinance. You can stay leveraged and use any profits to live on and buy more property (Until - not infrequently - things go bust and the bank owns the building.) A different case might be a condo development: Private investment (rolled over from selling another property and repaying THAT loan) and loans to buy the land, loans to build, sell 60% of the units, - and there might be enough to repay most of the loan.
  - jimberlage 3y ago
    I don’t think this is the typical borrower profile now, but balloon loans are historically for people who have most of the cash needed for development (or who have all the cash needed and think that they can get a 10% return while their interest rate is 6% over the life of the loan.) In that case, since you already have most of the capital lying around, a balloon payment lets you use other cash but you’re not worried about a large payment. Seems like a lot of commercial real estate is structured as a balloon loan to people who may not be able to make the lump sum payment, which is probably where the underwriting failure lies. Refinancing is a tool a savvy borrower can use as rates go down, but it’s not a strict expectation that you do that if you get a balloon loan, even on short term loans.

rufus_foreman 3y ago

>> That doesn't work for residential, because single-family homes don't usually make money, so residential homebuyers don't typically have ~$200,000-$2,000,000 in cash at the end of the 30 year period Before the US government got involved, the typical real estate loan was a 5 or 10 year balloon loan that had to be refinanced at the end of the loan period. Large part of them were interest only. So that's exactly the way it used to work. That blew up during the Great Depression. Then the government stepped in and started subsidizing loans which is where we're at now, the mortgage market in the US is very different than in say Canada or Europe.