Someone pitched me a deal recently. It was a good one honestly, going it at an 11% cap, with upside… (we will be accepting investors for the opportunity so feel free to reach out if you are an accredited investor. My email is jl@livikapital.com)

The sponsor came to us showing that he sourced debt at 7%, interest only for 3 years, on a five year term. Not the most exciting rate, but it is what it is these days…

Nevertheless, due to the extraordinarily high cap rate, the deal has positive leverage on day, and the cash on cash return on the deal is through the roof. (Positive leverage is when the unlevered yield of an investment is greater than the loan constant. When this occurs, the borrowed funds improve the deal level cash on cash returns.)

I only pointed out one thing. It may be better not to take the interest-only period.

It may actually be better to amortize the debt from day one. (Amortizing debt simply means to pay down principal as part of debt service payments.)

Why?

First of all, it protects the downside. Paying down debt means there is… less debt. And especially when you are in volatile times, lowering your debt load could be a life saver on deals that could otherwise run into hard times. (You could just ask all of the people who are struggling to pay down their high leverage bridge financing with permanent loans that are 4% more expensive.)

But that’s not the main reason why it may make sense to amortize the debt.

When your interest rate is 7%, your loan constant is 7.98% (on a 30 year amortization). Only 98 basis points higher that your loan constant when you pay interest only.

The difference between the loan constant and the interest rate goes down, as interest rates increase.

As interest rates go up, it makes less and less a difference to your cash on cash to amortize your debt.

If interest rates are at 3%, amortizing the debt on a 30 year schedule translates to a 5.06% loan constant. A 200+ basis point delta!

It is something we should all bear in mind as interest rates increase.

Simply put, I/O periods are not as valuable as they once were. Because they don’t translate to significantly lower debt service.

Therefore, in this new environment of sky-high interest rates, interest-only debt will be less of a must when it comes to analyzing deals. It very often may not even be worth the risk.

Fantini and Gorga put out a fantastic chart that does a great job highlighting the loan constant based on different interest rates and amortization periods. Studying this chart is probably the best way to become comfortable with these concepts. The chart could be found at https://www.fantinigorga.com/publications/Constant-Chart.pdf.