What is an Interest-Only Loan in Commercial Real Estate?
An interest-only loan is a type of loan in which the borrower only pays the interest, not the principal, for a specific amount of time. This period is typically be laid out in the loan agreement. After the interest-only period of the loan ends, the loan becomes a typical, amortizing loan, in which the borrower contributes to both the interest and the principal of the loan with each payment.
The Benefits of Interest-Only Loans for Commercial Real Estate Investors and Developers
The most important benefit of interest-only loans in commercial real estate is the fact that they allow a property or business to have significantly more cash flow during the interest-only period. Since a borrower doesn't have to worry about paying off the principal for a few years, they have a lot more flexibility. This often means they can reinvest any profits they might have back into the business. Plus, in multifamily real estate developments, an interest-only period takes a lot of the pressure off a developer to have an extremely high occupancy rate from the start.
Many, if not most commercial construction loans have an interest-only period which is designed to last for the duration of the project's construction. That way, a developer doesn't have to worry about making payments on the principal until they can begin to realize some revenue from the project. In addition, many bridge loans and most mezzanine loans are interest-only, and certain CMBS loans are interest-only as well. Freddie Mac and Fannie Mae also offer interest-only options for some of their products, like Freddie Mac Fixed-Rate Conventional Loans, Freddie Mac Seniors Housing Loans, and Fannie Mae Reduced Occupancy Affordable Rehab Loans.
The Drawbacks of Interest-Only Loans in Commercial Real Estate
Despite the benefits that interest-only loans provide, they have several disadvantages as well. Most importantly, when a borrower isn't paying any of the loan's principal, their loan payments get significantly larger when the amortization period of the loan begins (larger than if it had been amortizing from the start). And, if a borrower isn't ready to handle these payments, they could default on the loan. Also, since a borrower won't have built up any equity in their property during the interest-only period, if property values go down, they could easily find themselves underwater on their mortgage (owing more than the property is worth.)