Credit unions have long been a staple in local markets serving communities that have been historically underserved by traditional financial institutions. Like banks, credit unions accept deposits, make loans, and provide a wide array of other financial services, but they do so as member-owned cooperative institutions.
Credit unions provide a safe place to save and borrow at more competitive rates in comparison to dominant financial institutions, which is a unique benefit their members can enjoy. Since credit unions are owned by the depositors, they tend to pay higher interest rates on deposits and charge lower interest rates on loans.
Credit unions offer a better financial product than brick-and-mortar commercial banks but are limited in size and geographic footprint. If a member leaves the immediate area, their financial life will be slightly more cumbersome and require some up-front planning. Generally, banks have more robust technology, larger footprints, and often more products and services, which makes them formidable competitors in retail finance.
The commercial real estate market
While credit unions may not necessarily offer as many products as banks, they still face challenges competing for market share in the product segments they do offer. These challenges philosophically mirror one product set in particular, and that is commercial real estate lending.
While credit unions may not dominate the commercial real estate industry in terms of business or commercial accounts, there has been notable growth in credit unions’ commercial real estate portfolios nationwide throughout 2022. Rightfully so, as this is a space where credit unions still have a lot to offer.
As credit unions continue to expand their commercial lending platforms, they tend to lean back on their strengths in terms of offering low rates with often flexible prepayments and no yield maintenance. Outside the innate advantages that credit unions have, there are creative ways outside of pricing to entice potential borrowers. One of the most overlooked and underutilized methods is to offer an interest-only period on the loans.
Advantages of interest-only periods
There are several advantages of credit unions offering interest-only periods on commercial loans:
- Increased loan origination volume: Interest-only periods can make commercial loans more appealing to borrowers, which can help credit unions increase their loan origination volume.
- Increased flexibility for borrowers: Interest-only periods can provide borrowers with more flexibility in managing their cash flow, as they can use the money they would have used to pay down the principal to invest in their business or cover other expenses.
- Reduced risk for credit unions: By offering interest-only periods, credit unions can reduce the risk of borrowers defaulting on their loans due to an inability to repay the principal.
- Competitive advantage: Offering interest-only periods can give credit unions a competitive advantage over other lending institutions that do not offer this option and attract new members to the credit union.
- Generating more revenue: Interest-only periods can generate more revenue for the credit union, as they can charge a higher interest rate on the loan, given that the loan is less risky.
What are some scenarios to offer interest-only periods?
Recapture equity through cash flow
The most common advantage from the consumer perspective on interest-only periods is that it gives borrowers the chance to recapture some of their equity through cash flow. This is by far the strongest selling point for a deal that has qualified credit. This is also particularly helpful if the loan-to-value of the loan may have been slightly lower than a competing offer. The borrower can bring in the equity on the front end so that the credit union has a lower exposure relative to the asset value.
However, the sponsor can still recapture some or possibly all the excess equity they put in initially through the property’s cash flow during the interest-only period. This is a great way to entice a potential borrower but should only be considered on the best credit quality deals.
Ramp up periods
Another potential situation could be for properties that are going through a ramp-up period or that won’t have stabilized cash flow in place at origination. For instance, office and retail landlords or owners often provide an incentive to the lessors, such as rent abatements if the tenant signed a longer-term lease.
The credit of the deal is enhanced now that the long-term lease is in place, but if the reduced cash flow of the asset during that initial rent abatement is not sufficient to service the debt, then the borrower has to come out of pocket to supplement the payments which in essence means they are putting additional equity into their deal. This also could create more risk if the borrower doesn’t have strong secondary income sources. An interest-only period would eliminate that risk.
It shouldn’t be handed out to everyone
It shouldn’t be taken for granted that all deals are different, and some unqualified sponsors may ask for an interest-only period. The strategy should only be employed if the credit union isn’t taking any additional credit or payment risk.
For example, if a retail space has a high vacancy, an interest-only period should not be given on the basis that the borrower will lease the vacancy at a later time. The leases should be inked with clear terms the underwriter can review. The increase in cash flow to service debt should be imminent, and the underwriters should be able to box in that risk.
Profitability comes from strategy
The CFOs reading this article are probably scratching their head, asking why we would voluntarily make less money on the loan overall. They are not technically wrong. Truth is that the loan could be slightly less profitable; however, if you run a profitability analysis over the term of the loan, you will find that it is arguably immaterial.
There are a lot of instances though where a credit union can make the loan more profitable by charging a higher overall rate on the loan or even shortening the amortization by the same period as the interest only, for instance, a two-year interest-only period followed by a 23-year amortization (instead of the common 25-year amortization). In these situations, it is pivotal to understand what terms the borrower values most in the deal.
If it means winning the deal against a bank, capturing another member, or another depository relationship, then this begs the question, is it worth employing this strategy? Would the respective credit union be better off without the deal? Chances are probably not, but every credit union should weigh the pros versus the cons. Going back to the innate advantages of credit unions, there is typically a personal relationship with the member. Credit unions should leverage this to truly understand the member’s business strategy in a way that a lot of lenders won’t, and chances are they may uncover more creative ways to win deals outside of pricing.