Interest-Only Period Ending: What Happens to Your Cash Flow
An interest-only period lowers your loan payment for the first few years by deferring principal, and it makes a deal look stronger on paper than it will look once amortization begins. When the interest-only period ends, the payment jumps, cash flow drops and your debt service coverage falls, often at the same time the business plan is supposed to be hitting its stride. The size of that jump surprises borrowers who underwrote the deal on the interest-only payment.
Take a $5 million loan at 6.5 percent, which costs $325,000 a year in debt service while it is interest-only. Once it begins amortizing over 30 years, the payment rises to about $379,200, an increase of roughly $54,000 a year. On a property producing $450,000 of net operating income, cash flow after debt service falls from $125,000 to about $70,800, a drop of more than 40 percent, and the debt service coverage ratio slides from about 1.38 to about 1.19.
Lenders understand this, which is why many test coverage on the amortizing payment even during the interest-only years. If your lender sized the loan on the amortizing payment, the step-up is already inside its numbers, but if it sized the loan on interest-only payments, the loan may be larger than the property can comfortably carry once principal begins.
Interest-only periods are often paired with value-add plans, on the theory that renovations and rent increases will raise net operating income before amortization starts. When renovations run late, rent growth stalls or expenses climb, the payment increase arrives before the income it was supposed to be matched with, and the owner covers the gap from reserves or a capital call.
Taxes can compound the problem in some states, and in Michigan a property's taxable value uncaps the year after a sale, so a buyer can face a higher tax bill and the end of an interest-only period within the same few years. A pro forma built on the seller's taxes and the first-year payment would miss both increases at once.
Many owners plan to refinance before the interest-only period ends, but that plan depends on interest rates, property values and lender appetite at a date you cannot control. If rates are higher or the property's income has not grown as planned, the new loan may be smaller than the old one, and the owner either brings cash to the closing or accepts the amortizing payment on the existing loan.
For syndicated deals, the end of interest-only is often the moment distributions shrink, and investors who were told about the payment step-up at the start take that news very differently from investors who were not. Offering materials should show cash flow under both payments, not just during the interest-only years, so nobody is surprised in year three.
The extension and maturity terms deserve attention for the same reason, because a loan whose interest-only period ends near its maturity date leaves very little time to fix a shortfall before the lender's deadline. Read when amortization starts, when the loan matures and what the extension options require before you sign the term sheet.
Before you accept an interest-only period, ask what the property's coverage and cash flow look like on the amortizing payment, and whether the deal still works if the business plan runs a year late. Make sure your reserves can carry the gap if it does, and treat a refinance as an option you might have rather than the plan the deal depends on.
A deal that only works while the payments are interest-only depends on everything going right, and you want to know that before you sign rather than in year three. I help sponsors model their loans through the full term and review term sheets for the amortization, maturity and extension terms that decide how much time they have. If you are weighing a loan with an interest-only period, send the term sheet to amer@awadcapitaladvisors.com, and I can help you see whether the deal holds up once amortization starts.