Permanent loans are those typically with a duration of 10 years and that have a fixed interest rate tied to the 10-year Treasury, The Wall Street Journal reported. They are attractive now because interest rates are expected to rise, says Joseph W. Donato Jr., a director in the Washington, D.C., office of L.J. Melody & Co., a Houston-based mortgage banking firm. L.J. Melody is a unit of Los Angeles-based real-estate services firm CB Richard Ellis.
Investors traditionally seek permanent financing when buying stabilized, or well-leased, properties, and when refinancing short-term floating-rate loans to lock in a rate. This kind of financing hasn't usually been offered to investors with properties that aren't at least 85 percent to 90 percent leased, in part out of concern that the investor won't be able to pay off the loan if more tenants don't appear. So investors buying buildings that weren't fully leased and that were in need of refurbishment, for example, had to use short-term floating-rate loans.
The rates on such loans float with the market so the investor's costs can swing up and down monthly. What's more, short-term loans are growing more expensive as the short-term rate index has been rising. So how can investors who want to buy buildings that aren't fully leased now but that have potential — or developers who want to build properties — obtain permanent financing from the start? One way is through an "earn-out" provision, in which the lender agrees to grant the investor a permanent loan, but with a portion held in escrow until certain parameters are met.
In this scenario, the investor would get some portion of the loan up front and then the remainder once the property produces enough cash flow to service the earn-out portion of the debt. There is usually a 12-month deadline set for the property to meet the parameter. If the investor doesn't meet the deadline, he or she doesn't get the full amount.
In addition to earn-out provisions, some lenders offer programs that allow investors in buildings — especially investors in apartment buildings — to increase their permanent financing with fixed-rate second and third mortgages that mature at the same time as the original first mortgage, provided the income and value have increased since the first loan was funded, according to Rick Hayward, a senior loan officer in the Palo Alto, Calif., office of Marcus & Millichap Capital Corp., a subsidiary of Encino, Calif.-based Marcus & Millichap Real Estate Investment Brokerage.
Fannie Mae and Freddie Mac, for example, offer those kind of programs on all apartment-investing loans over $3 million, Mr. Hayward says. Typically, the minimum second- or third-loan amount is $500,000. The property has to experience a corresponding increase in value.
Another option: agreeing to take a lesser loan amount, meaning the investor would have to put up more cash. Lenders will provide a permanent loan to investors with buildings that aren't more than 85 percent leased but not for as much as they would if the building was stabilized.
The motive behind these two strategies is to lock in today's interest rates for a long period, rather than waiting until the property is stabilized to obtain a permanent loan. Permanent financing does have its drawbacks. David Sonnenblick, a principal of Los Angeles-based real-estate finance firm Sonnenblick-Eichner Co., points out that prepayment penalties can be substantial.
Also, if the investor wants to sell the property before the loan term is complete, the new buyer may not qualify to assume the loan. These conditions make it harder for an investor to sell the property, he says.
