The balloon nobody mentions

Residential borrowers have one clock. They borrow for thirty years, they pay for thirty years, and at the end they owe nothing. Commercial borrowers have two clocks running at different speeds, and the gap between them is the single most consequential feature of the loan.

Two clocks

The amortisation is the schedule the payment is calculated on — usually twenty-five or thirty years. The term is when the loan matures — usually five, seven or ten. On the maturity date the entire remaining balance is due, and on a thirty-year amortisation ten years in, that balance is around 82% of what was borrowed.

What that means in practice

It means every commercial loan has a refinancing event built into it, and the terms of that refinancing are unknown when the loan is written. A property that comfortably covered debt at 5% may not cover it at 7.5%, and the maturity date does not move to accommodate that.

How to hold it

• Match the term to the lease term where you can. A ten-year loan behind eleven years of lease is a very different risk from a ten-year loan behind four.
• Know the prepayment structure before you need it. Yield maintenance and defeasance can make an early refinance uneconomic even when rates fall.
• Model the balloon at a rate you do not like. If the property cannot refinance at 200 basis points above today, the term is too long or the loan is too big.