Adjustable Financing
Makes a Comeback

With interest rates on the rise, investors increasingly are trying to hedge or lock in rates on loans and mortgages. So lenders and mortgage companies are dusting off -- and sometimes tweaking or expanding -- some methods of financing that weren't necessary when interest rates were at historic lows.

Two such methods are capped adjustable-rate mortgage financing and float-to-fixed-rate hybrid loans.

Both loans cap or lock interest rates at a certain level, even if interest rates go higher. But in some cases, investors may have to pay an upfront premium or certain fees to take advantage of them. What's more, investors signing up for these loans face the risk that interest rates could fall lower than the rates set on these mortgages.

Minimizing Downside

Capped ARM financing works like this: A borrower takes out a floating-rate loan where the lender agrees to cap how high the rate can go. ARMs are tied to short-term interest rates, so investors choosing such a loan would get starting rates lower than investors who go for fixed-rate loans. That's because fixed-rate loans are tied to long-term rates, which are currently higher than short-term interest rates.

"Capped ARMs allow borrowers to take advantage of low short-term rates and [minimize] their downside risk through an embedded cap," says Jay Wagley, a managing director in the Dallas office of Houston-based mortgage banking firm L.J. Melody & Co.

Mr. Wagley adds that by using a capped ARM, versus a fixed-rate loan, the borrower can ultimately end up with substantially higher cash flow after debt service.

Another advantage of capped ARMs is more favorable and flexible prepayment penalties, says William T. Hyman, a managing director at mortgage lender PW Funding Inc., a subsidiary of CharterMac, a New York-based finance company.

Capped ARM financing typically allows the borrower to prepay after the first year of the loan's term without a hefty penalty fee. After that first year, the prepayment penalty cost is locked in, often at 1% of the loan amount outstanding, compared with as high as 20% for conventional loans. (Penalty costs on conventional loans are calculated by factoring in whatever the interest rate is at the time.)

Alternatively, Mr. Hyman says, the capped ARM prepayment penalty can be laddered in what's known as a stepdown, where the penalty is 5% of the loan amount outstanding in the first year, 4% in the second year and so on.

Lenders and mortgage companies are trying to expand their market by offering capped ARMs to investors of apartment buildings, not just home buyers. Fannie Mae, Freddie Mac and Washington Mutual Inc. are among the companies offering these mortgages to commercial investors.

Letting It Float

The float-to-fixed-rate hybrids, which can be used for all kinds of commercial-property transactions, work like this:

A borrower gets a 10-year loan from a lender. The first six to 18 months of the loan is floating rate. After that period, the loan converts to a fixed rate that has been negotiated upfront and is set at the loan's origination.

"This strategy allows the borrower to continue to take advantage of the lower interest costs in a floating-rate loan for the initial six to 18 months of the loan term, while allowing the borrower to lock in today's current fixed rates in advance of an expected increase in interest rates," says John H. Pelusi Jr., executive managing director and managing member at Holliday Fenoglio Fowler LP, a Houston-based real-estate banking firm.

Of course, during the floating period, the borrower is exposed to increases in the short-term benchmark rate and the fixed rate could end up being higher than the market rate if interest rates fall during the period of the loan.

Some of these loans allow the borrower to convert back to a floating-rate loan during the last 12 to 24 months of the loan term, says Mr. Pelusi. Once the loan is converted back to floating rate, the borrower can pay the loan off without a prepayment penalty, he adds.

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