Comment by NewJazz | Hacker News Reader

Comment by NewJazz | Hacker News Reader

Unlike US home loans, commercial mortgages are almost entirely interest- only. That means developers of large properties tend to have low monthly payments, but face a balloon payment equal to the original loan the day the mortgage comes due.

That is an odd detail I was not aware of... this seems to be a significant advantage for commercial mortgages over residential ones. Are they less leveraged or something? That doesn't square with the "40 per cent of office loans on bank balance sheets were under water" statement later in the article.

This is not driven by fundamentals; this has everything to do with financing costs going back up

Seems like a disingenuous statement. Demand for office space has fallen. And according to the article, demand was overstated when these now-due loans were originally made.

“Everyone will blame Covid [for] the losses,” said John Griffin, a professor at Texas university. “But Wall Street’s aggressive underwriting of commercial mortgage debt is going to make the situation a whole lot worse than it would have been.”

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.

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.

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.

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.

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.

>> 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.

> this seems to be a significant advantage for commercial mortgages over residential ones.

"Interest only" loans are not really advantageous. It means by default you are never paying down your principal and you are forced to refinance when the balloon payment is due (usually 5 years or so). So if you signed a loan when rates were low, you would have been better off to get a long term 30 year fixed interest loan. Otherwise your payment can more than double or triple right along with interest rates.

And since you're not paying down the principal, it's easier to find your loan under water. Although it is typical for commercial real estate loans to require a 20% down payment.

This kind of mortgage was very popular before 2008. Many US homes were mortgaged at interest only rates. People however saw how dangerous this can be in the aftermath of the great recession, as a record number of Americans lost their homes.

You can get residential interest only mortgages - at least here in the UK.

I used to have one, but remortgaged to repayment ten years ago.

It's quite common to see "buy to let" mortgages as interest only rather than repayment, where the owner is concerned with cashflow rather than the asset itself.

The owner can also make money on appreciation still, even if they don’t ever pay down any principal.

You can - at least some places - get residential mortgages that are interest only too, but they're not popular for good reason because of the risk involved.

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