A Penny for Your Thoughts

Alec J. Pacella, CCIM

I’ve always been a fan of listening to music and some of this is the result of a famous promotion in the 1970s through 1990s by a mail-order music distribution powerhouse known as the Columbia House Record Club. And who could forget their offer – becoming a new member would allow you to order 12 cassettes (or, depending on your vintage, albums, 8-tracks or CDs) of your choice for a mere penny. That’s right, just one cent. But of course, there was a hook. Over the next year, you were obligated to buy a dozen more titles, but this time at retail-plus pricing.

To me, the recent increase in mortgage interest rates reflects a similar scenario – borrowers flocked as rates plummeted to record lows hovering around 3% the last few years. We all knew there would be a hook, in this instance, the very real risk of future increases in interest rates. But the more that banks lowered mortgage interest rates, the more that borrowers would refinance existing loans. Some of these were likely good decisions while others may not work out so well. This month, we are going to discuss a process to analyze the decision to refinance. And while it seems that the horse named “refinancing” has officially left the barn, understanding this process may bring to light some other considerations. Historically, borrowers have followed a rule of thumb based on the spread between their existing contract interest rate as compared to the interest rate currently available. The typically go/no-go decision has historically ranged from 1.5% to 2%. However, this approach has several pitfalls. It ignores the costs associated with refinancing. It also fails to discount any future benefit of refinancing, as well as recognizing the impact of the borrower’s anticipated holding period. Finally, it ignores any reinvestment of equity taken out as a result of the refinancing. The concept of net present value (NPV) helps to overcome these pitfalls. The following example will illustrate. Ten years ago, a borrower secured a $300,000 mortgage to finance the purchase of a small real estate investment. The contract interest rate was 6.5%, and it was amortized over 30 years with an associated monthly payment of $1,896. The current loan balance, now 10 years later, is $254,329. However, interest rates have fallen, and the borrower has found a lender that will refinance the existing loan balance at a rate of 5%. The new monthly payment, assuming the amortization period is reset for a new 30-year period, would be $1,365 and total upfront costs, including fees, would be $8,550. Finally, assume the borrower could invest any cash flows because of the savings in monthly loan payments at 5%. Based on this outline, should the borrower refinance?

Month	Cash Flows if No Refinance	Cash Flows if Refinance	Difference	Present Value of Difference
0	$0	($8,550)	($8,550)	($8,550)
1 thru 48	($1,896)	($1,365)	$531	$23,058
48	($225,988)	($238,128)	($12,140)	($9,943)
Table 1				$4,565

Part of the answer is “it depends.” In this instance, a primary consideration is length of time the new loan is expected to be outstanding. Refinancing will lower the borrower’s monthly loan payment by $531 ($1,896 originally as compared to $1,365 if refinanced). If the new loan is anticipated to be held for four years, the remaining balance at that time would be $238,128, whereas the remaining balance on the old loan four years later would be $225,988. We now have all of the necessary information to analyze this decision, as summarized in Table 1. The cost to refinance ($8,550) will occur upon refinancing, considered month 0. The savings in monthly payment ($531) will occur each month for 48 months. Discounting these amounts at the expected 5% reinvestment rate results in $23,058, which is the present value of this savings. Finally, the difference in loan balances at the end of four years is $12,140. Again, discounting this amount at 5% results in $9,943, which is the present value of this difference. The net result (or NPV) of $4,565 indicates that, under this set of circumstances, the borrower should refinance.

Digging a little deeper, the refinancing decision is sensitive to several things. An obvious one is the upfront costs associated with refinancing. In the example above, the borrower could absorb an additional $4,565 in costs (or $13,115 in total upfront costs) and still be financially better off by refinancing. Another consideration is the amount of time the refinanced loan will be outstanding.

Month	Cash Flows if No Refinance	Cash Flows if Refinance	Difference	Present Value of Difference
0	$0	($8,550)	($8,550)	($8,550)
1 thru 48	($1,520)	($1,680)	($160)	($6,617)
48	($207,777)	($230,322)	($16,717)	($26,717)
Table 2				($41,884)

In this scenario, the NPV will increase the longer the new loan is held. For example, if the new loan is expected to be outstanding for 10 years instead of four years, the NPV, or economic benefit of a refinance would increase to $17,299. However, just like that one cent offer from Columbia House, the proverbial sword we call interest rates cuts both ways. Let’s now consider what we have seen over the last 10 years. Suppose that the $300,000 loan that I put into service in late 2013 carried a rate of 4.5%. It’s now 10 years down the road and I’m considering refinancing, but facing a rate of 7.5%. All of the other assumptions are the same as the previous example; the old loan was amortized over 30 years, the new loan will have upfront loan costs of $8,550 and also be amortized over 30 years and either loan is expected to be held for four more years. Table 2 represents the revised analysis.

Historically, borrowers have followed a rule of thumb based on the spread between their existing contract interest rate as compared to the interest rate currently available. However, this approach has several pitfalls.

Common sense tells us that no one in their right mind would willfully choose to refinance an existing loan carrying a 4.5% with a new loan carrying a 7.5% interest rate. And this analysis brings the cold, hard economic facts as a refinancing event will result in a NPV of $41,884. And this brings me back to Columbia House Record Club. Accepting that one cent deal initially resulted in a dozen new records in your collect, but it came with a risk. You also entered into a contract that obligated you to buy a dozen more titles over the next year, often with a narrower selection that now required “retail plus” pricing. My loan examples omitted a very common nuance in commercial mortgages – a mandatory payoff event commonly called a balloon or call. While no one in their right mind would choose to replace a lower interest rate loan with a higher interest rate loan, the presence of a balloon changes this from a choice to an obligation. And the current environment offers limited choices with “retail plus” pricing.

While no one in their right mind would choose to replace a lower interest rate loan with a higher interest rate loan, the presence of a balloon [could change] this from a choice to an obligation. And the current environment offers limited choices with “retail plus” pricing.

After peaking in the early 1980s, poor audio quality, a sketchy business model and artist backlash associated with little to no royalty payments resulted a slow but steady decline in popularity for Columbia House. The final blow was the arrival of streaming services starting with Napster in the early 1990s. And while the foundation of the mortgage industry is significantly broader and more secure, borrowers need to keep in mind that all of those terrific offers of yesterday can come at a terrific cost tomorrow.

What I C @naipvc

ANY TAKERS? The appetite for investment in Cleveland’s downtown office market will be put to the test over the next six months. 200 Public Square was put on the market last month and is rumored to be joined by 1100 Superior Avenue in early 2024. Other office towers with ownership in flux include IMG Center, Fifth Third Center and Ohio Savings Plaza. –AP

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