Options for Co-op Boards When Refinancing Underlying Mortgages
Many articles are written about cooperative (co-op) mortgages from a shareholder’s perspective. This article discusses the basics when it comes to refinancing the underlying mortgage of a residential co-op building. Having this understanding will help you and your fellow co-op board members navigate the many refinancing options that are available to you and your fellow shareholders.
What makes co-op purchases unique?
When you buy a co-op, you are not directly purchasing real property, you are purchasing shares in a corporation that owns real property. In addition to receiving shares of stock, you receive a proprietary lease for the unit you are purchasing. When you purchase shares in a co-op there are typically two mortgages that need to be paid. 1) Your personal mortgage (money received from your bank to buy the shares of stock) and 2) An underlying mortgage that the corporation owes to a bank or other lending institution.
Why Co-ops Have Mortgages
Many co-ops have underlying mortgages because one of the basic principles in real estate is leverage, meaning using other people’s money (OPM) to increase returns. Just like people go to a bank to borrow most of the purchase price to buy real estate (or co-op shares), builders and investors of residential properties must borrow money to build and/or buy their properties. When a co-op comes into existence this underlying mortgage, from the builder/investor, or prior rental property owner (if your building was converted from a rental building to a co-op) is transferred to the co-op corporation. The building is used as security for this underlying mortgage. As with any other mortgage there are monthly payments on this debt. Since all cooperators own shares in the corporation (co-op) all shareholders must share in the payment of the debt. A portion of the monthly maintenance charges that are paid by the shareholders is used to repay the underlying mortgage debt.
Lending institutions offer a variety of mortgages. Cooperatives have the option to choose the type of rate, loan amortization length, when principle is due, and several other options. Let’s discuss a few of the options available.
Options Available for Coop Mortgages
The menu of options allows you to customize a loan to your cooperative’s needs.
What factors affect your choice of mortgage?
Before committing to a mortgage it’s important to understand why you are refinancing your mortgage and how each of the options above helps you achieve your objective.
For example, if your objective is to keep your monthly maintenance charges as low as possible you may choose an interest only mortgage or a 30-year amortized loan paid for over a period of 10 years with a balloon payment after the ten years. The upside of these two options is that your monthly mortgage payment will be lower than a 30-year fully amortized loan (monthly payment of principle and interest) but there is a downside. The lower monthly payment options will leave you with debt at the end of the mortgage term. Your cooperative may find itself having to refinance the unpaid principle during a period of high interest rates.
The chart below will help you determine how each option effects your monthly payment and remaining debt at the end of the mortgage term.
Yield Maintenance
One term you may come across when looking to refinance the underlying cooperative mortgage is yield maintenance.
Yield Maintenance is a prepayment penalty. What makes yield maintenance so intimidating to non-financial board members is the complexity of the prepayment penalty calculation.
The calculation computes an amount that the co-op must pay, in addition to the unpaid principle balance, that allows the lender (bank) to attain the same investment return (yield) as if the co-op had made all scheduled mortgage payments under the terms of the loan agreement.
In other words, if after 6 years your co-op decides to refinance its 10-year, 6% loan, from Bank A, and replace it with a 4% loan from Bank B. Your yield maintenance prepayment penalty will be an amount when added to your unpaid principle balance (you still owe the bank principle since you have 4 years left on your mortgage) that will ensure Bank A earns the same return as if your co-op made all your payments over the full 10-year loan term. The yield maintenance calculation assumes that Bank A will invest all the funds in US Treasury instruments. The calculation of the yield maintenance requires present value calculations that you typically find in finance courses.
Other, more simple prepayments penalties involve a sliding percentage as you get closer to the maturity date. For example, a 5% prepayment penalty with five years remaining until maturity, reduced to a 4% penalty with four years remaining until maturity, reduced to a 3% penalty with three years remaining, and so on.
It’s important to understand your prepayment penalties because excessive penalties may hinder your ability to refinance your mortgage in the future.
Line of credit
We recommend that in conjunction with the refinancing of your underlying mortgage cooperatives should obtain a line of credit (LOC). A line of credit gives your cooperative access to additional cash on top of the net proceeds of a refinance. With LOCs you only pay interest on the money you borrow. There is an annual fee to keep the line active.
Summary
Many major banks and insurance companies offer refinancing of the underlying co-op mortgage. Your co-op should have no problem finding money when you need it for major capital improvements or refinancing of existing loans that are about a come to the end of their term. Understanding your choices will allow you to customize your loan to meet the needs of your co-op.