Top 5 Tips to Optimizing Debt
The Commercial Real Estate world runs on debt. Without it, the industry as we know it would not exist. Commercial debt is what allows the real estate world to go round. But for many real estate professionals, debt is just the thing they need in order to make a transaction happen.
We’ve said it before and we’ll say it again — debt is the most expensive cost center you’re not thinking about. Mostly because it’s so time consuming. So we decided to help out. Here’s five of our favorite tips for optimizing your debt.
#1: Make sure your loan tenure aligns with your business plans
Your loan term plays a huge role in the costs you will incur; everything from your spread to your prepayment penalty is affected by your loan term. Longer loan terms generally feel safer but that can come at a cost. Entering a loan with a maturity that is significantly longer than the amount of time you plan to hold the asset can have a significant impact on your return metrics (IRR, CoC, etc).
Generally, it’s a good idea to try and match your financing terms to your planned hold period for the asset. Not aligning your hold term with your loan term creates a costly inefficiency, especially through the yield curve and your spread. Decrease the inefficiencies that come with a term mismatch!
Learn more about Term Mismatch and What It’s Costing You.
#2: In general, use floating rate debt whenever possible
If you're strictly looking at fixed vs floating from an interest rate perspective, floating is almost always cheaper than fixed rate debt. The longer the time horizon, the greater the likelihood that the floating rate loan is cheaper than the fixed rate loan. This is because the market generally overestimates the path of Fed Funds.
Floating rate debt generally comes with less punitive prepayment penalties as well, increasing their attractiveness — especially if you decide to exit before maturity.
Of course, there’s always exceptions to the rule — we can’t make guarantees about where rates are going… But historically, choosing fixed has resulted in overpaying on interest expenses by a lot. And when it’s more expensive to float, it’s usually only a little more expensive.
Read more about choosing Fix v Float.
Or download our eBook to learn more about the Hidden Cost of Fixed Rate Debt.
#3: Carefully abstract your loan documents for easy reference
There’s nothing worse than an emergency related to your loans and not being sure where that information lives. Then you’re scrambling to find the information you need in your docs and stressing even more.
What happens when your DSCR suddenly slips below the covenant requirement? Having that information on hand and ready to reference quickly can mean making debt decisions faster and avoiding bad outcomes.
#4: Negotiating your prepayment terms
Debt is the biggest cost center you’re not paying attention to, and the prepayment penalty is often the biggest offender. We know you consider your prepay when choosing a loan, everyone does, but what if you were to translate that penalty as an interest expense?
Discover how thinking of your Prepayments (as as Effective Interest Rate) will help you.
The penalty to exit a loan early can be prohibitive, and has blown up more than one deal — maybe even one of your own. Try to make your prepayment provisions as favorable as possible to keep you from missing out on exit opportunities or diluting returns.
#5: In 2022, be wary of LIBOR loans
Counterparties were encouraged to stop entering new LIBOR-based contracts by year end 2021 as regulators confirmed LIBOR will cease to be representative or provided as of June 30,2023. Don’t forget to make sure that any index replacement language isn’t punitive towards you.
Review the fallbacks on your loans. If the replacement index matches the ISDA fallback for hedges, the transition to SOFR should be a non-event. But if the replacement doesn’t match, LoanBoss has a LIBOR Fallback report to make it easier to understand what’s to come.
You want to make sure that any changes to the rate are net neutral, and that the language matches the index replacement on any hedges you might have in place to protect you from a mismatch and a forced termination.
At LoanBoss, we live and breathe debt. We have several features to help you manage your debt better; from instant loan doc PDFs to customized reporting, we’re constantly adding new ways to make your lives easier. We hope that this list of tips has helped you become smarter about the way you manage debt on your own deals!
How else can we help? Check out what else LoanBoss has to offer!
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