I love financial analysis. Whether it’s a mortgage refinance, an acquisition, or just looking at my own spending, the process of building a financial model and digging into the numbers to solve a problem is very satisfying. And when I can provide my services to a client with a tricky financial situation, it’s even more fulfilling.
In addition to running this site, I also own a consulting business. What started out as serving mostly healthcare clients from my old corporate jobs has now migrated into providing private financial advisory services to individuals and small businesses.
Recently, I have been working with a private finance client on whether or not to refinance a commercial mortgage and I thought I would share with you some of the details about the project.
The client is a retired widow in her mid 60’s. Her husband passed away about three years ago after a lengthy illness. She is in good financial shape as her husband earned a decent income as a business owner, did a good job saving and investing in various assets, and had prepared for his own passing.
I was hired to analyze her options for refinancing the mortgage on a commercial office building that she owns. The building houses her husband’s business as the sole tenant. After her husband passed away, she sold his business to the remaining management team and they have been operating in the building ever since.
The building was constructed in 2008 and funded with a $2.7 million 15 year mortgage that matures at the end of 2023. The interest rate on the outstanding principal is variable and resets monthly at 1 month LIBOR plus 1.40%. Principal payments are made monthly according to a specific schedule with relatively equal payments throughout the remainder of the loan term.
In addition, at the beginning of construction (beginning of 2008), the client’s husband was concerned about increasing interest rates on the variable rate mortgage. As such, he entered into an interest rate swap agreement whereby on a monthly basis, he received a floating payment in an amount exactly equal to what he was required to pay on the mortgage. In exchange, he paid a fixed rate of 6% on the outstanding balance. Essentially, the swap converted the mortgage from a variable rate into a fixed rate.
Unfortunately, the timing of the swap was not favorable for the client. The variable interest rate is tied to 1 month LIBOR which was 4.57% when the agreement was initiated. Shortly thereafter, LIBOR began a free fall throughout 2008, dropping below 1% and never again since then has it been above the 1% level. The financial impact has been that the client has paid significantly more in interest expense than they would have had they remained unhedged.
After the death of the owner, my client sold the business to the remaining management team. At that time, they entered into a lease agreement paying $20K per month with the same timeframe as the mortgage and swap agreement.
With another 7 years remaining on the mortgage and swap agreements, I was hired to analyze different refinance scenarios.
The proposed options included the following:
- Continue under current terms with both mortgage and swap
- Pay off swap, leaving existing mortgage in place
- Pay off both mortgage and swap
- Refinance mortgage
1. Continue under existing terms
The easiest approach is to continue paying the mortgage and swap agreement under the existing terms.
When my client sold the business in 2013, she made a $500,000 prepayment on the mortgage. As such, the floating rate payments on the mortgage and those received on the swap are no longer aligned. The floating rate payments received on the swap are slightly larger than the floating rate payments on the mortgage. Additionally, due to the prepayment, the mortgage will now be repaid at the beginning of 2023.
The remaining payments are as follows:
2. Pay off swap, leaving existing mortgage in place
After requesting a payoff from the swap counter-party, we received an offer of $287,000 to terminate the swap. The termination value is a discounted value of the future payments due under the agreement. The termination value factors in the discount rate and assumption of LIBOR over the remaining life of the swap.
If the expectation is that interest rates will increase, the termination cost of the swap would decrease. And as time passes and payments are made on the agreement, the termination cost will decrease.
Assuming LIBOR stays where it is today (at approximately 0.46%) using an 8% discount rate, the termination cost of the swap will decline as follows:
6/30/2016 – $287K
12/31/2016 – $246K
12/31/2017 – $183K
12/31/2018 – $130K
12/31/2019 – $88K
12/31/2020 – $55K
12/31/2021 – $30K
12/31/2022 – $12K
3. Pay off both mortgage and swap
With the remaining balance of $1.2 million on the mortgage, plus $287K to terminate the swap, the client will need to spend a total of $1.5 million to terminate both agreements. This would require the client to liquidate a significant portion of her retirement assets to fund.
4. Refinance mortgage
Rather than using her other retirement assets to fund the mortgage buyout and swap termination, she could use proceeds from a refinance.
In 2013, the building appraised at $2.1 million. With the $1.2 million mortgage plus the $287K to terminate the swap, this would require a minimum 71% debt-to-equity ratio. Assuming a 4% interest rate and 15 year amortization, the client could reduce her annual payments from $250K to $133K per year.
This option has the highest ROI and results in lowering her annual payments, but it would extend the term by another 7 or 8 years.
I met with the client earlier this week and went through the options. We made a decision, but before I share what we decided, I would like to hear from the readers.
Readers, which scenario would you recommend for this client? And why? Or do you have another option not listed?