Commercial Loans Blog

Commercial Loan Resets

Posted by George Blackburne on Mon, Aug 7, 2017

Rates.jpgWhen you get an adjustable rate home loan, the Promissory Note is always very, very precise about any interest rate readjustments.  For example, "Every six months the Rate will readjust to 3.57% over the weekly average yield on 12-month constant maturity Treasuries."

When most banks write a 10-year, fixed rate commercial loan, there is almost always a provision that calls for one rate readjustment or "reset" at the end of five years.  The rate is then fixed for the next five years.  This is as close as you're likely to ever get to a 10-year, fixed rate commercial loan on an office building or industrial building.

 

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What has always amazed me is that the language surrounding the rate readjustment is often very loosey-goosey.  Instead of saying that the rate will adjust to so many basis points over some index, the language will effectively look like this:  "At the end of five years, the loan will readjust to whatever rate the bank is charging on similar loans at that time."

Really?  That loosey-goosey?  Yup.  Often these fixed rate commercial loans from banks are larger than $2 million, but no one seems to care that the borrower is completely at the mercy of the bank.    Legally the bank could raise the rate from 5.5% to 7.5%, even though other banks are quoting just 6.0% at the time.  Later I will explain why this is not really an issue.

 

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A rate reset is more than just a rate readjustment.  The amortization of the loan is also accelerated.  For example, the typical bank permanent loan on an office building is a fixed rate, ten-year loan with a rate reset at the end of year five.  Most bank permanent loans start out with a 25-year amortization, but when the monthly payments are re-computed at the rate reset, we are five years into the loan.  Therefore the remaining loan balance is reamortized over just 20 years (although it is still all due and payable at the end the the next five-year period) at that time.

 

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So why don't commercial borrowers freak out over the loosey-goosey language of the rate reset?  For some reason commercial bankers don't believe in capitalism.  They don't believe in charging whatever interest rate the market will bear.  Bankers think it is a sin to charge a higher interest rate than the bank down the street.  

As a result, banks across the country almost always charge about the same interest rate for commercial real estate loans.  Remember, a banker would consider himself a sinner if he charged a higher interest rate than his competitor, as if he was some sort of filthy capitalist.

 

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Now you might find a 0.25% to 0.50% difference between banks on commercial real estate loans, but you will almost never see one bank quoting 5.5% and another bank 7.5%.

 

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Okay, let's review what you've learned today:

1.  Rate readjustments are called resets in commercial mortgage-ese.

2.  Most commercial loans have a 25-year amortization.

3.  Ten years is usually the longest term available on a fixed rate, commercial loan.

 

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4.  The rate will reset at the end of year five to whatever rate the bank is then charging.

5.  The interest rate reset language is usually surprisingly loosey goosey.

6.  Banks around the country charge almost same the same rate on commercial loans.

 

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7.  Banks do not charge whatever the market will bear.  Capitalism is bad.

8.  It is a sin for a banker to charge a higher interest rate than a bank down the street.

9.  Therefore borrowers rarely get hit with an above-market rate increase at the reset.

 

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Topics: Commercial Loan Resets