I'm evaluating the returns of a longterm (15-year) hold. My automatic assumption was that an interest-only loan would be less accretive to returns (IRR and EM) than an amortized loan assuming both match the hold period of 15 years. Shouldn't it virtually always be, since you're paying less on total interest with an amortized loan, all things equal? (I don't think it should matter for the end result, but note that I am cashflow negative throughout the entirety of the hold period with an amortized loan period, and I'm cashflow positive for 90% of the I/O period; I'm funding the shortfall with contributions but should see that all come back to me at sale.)
Currently in my model I'm seeing a levered IRR of 8.7% and EM of 2.7x with an amortized loan, but an 11.6% IRR and 3.9x EM with an I/O loan. (For reference, the unlevered IRR and EM are 7.5% and 2.2x.) This sort of delta holds firm right up until the sales price is < or = to the purchase price. I understand that short hold periods and value-add plans benefit from I/O loans because the returns are driven mostly by the reversion value. But still, shouldn't an amortized loan always outperform this, if cash flow isn't an issue?
TL;DR - How would you explain an I/O loan outperforming an amortized loan on returns, especially on a long-term hold (all things equal)?
I/O loans usually result in higher IRR & cash on cash but lower EM. The increased cash flow up front vs at the end of the sale is what causes the higher IRR. IRR is the discount rate that makes the NPV = 0, so cash flow occurring earlier will be less discounted. All things equal, I would think the longer the hold, the larger the delta between the IRR on an IO vs amortizing loan because the reversion value would be more heavily discounted.
2 caveats - 1) The interest rate is likely going to be higher on a I/O loan vs full amortizing since the lender needs to be compensated for their increased risk on the back end of the deal and lower cash flow during the loan term. 2) I have never heard of a loan with a 15 year I/O period. It’s hard enough to get 5 years these days.
Additionally, if you are planning on holding an asset for 15 years, you are probably focused more on EMx than maximizing IRR.
Hey I appreciate the feedback. For context, I'm thinking through negotiations on an owner financing deal, hence where a 15 year I/O "might" come into play. But now that I think about it, it would (kind of) defeat the tax deference strategy for the seller. But still, this exercise has me thinking.
That all makes sense. I'm not totally surprised the IRR is higher with the I/O loan (especially compounded over a pretty long hold). But I am surprised the EM is showing as higher with the I/O too. I think my methodology for capturing the EM is misleading since it counts the negative cash flows resulting from the amortized loan as contributions (which isn't exactly wrong but...). If I change something like the rent so that the investment is always positively cashflowing, my contributions remain low (= contributions under the I/O loan scenario) and the EM now shows as higher with the amortized loan.
depends if owner operator or fund.
if owner you can reinvest the difference and make more money. Assume ~10-12% baked in pp with a 10 year amort. there is around a 1-2%- delta annually from the payment. THis might be small, but when playing with larger deal the chunk dollars might be higher/more meaningful. E.g. if 1% difference is $1mm in NCF, then you could raise an LP fund around that and in another 5-6 years leverage it to $3mm, assuming 3x from the GP to LP waterfall. Do this every year with the delta and you make considerably more money.
If you're underwriting the same rate in both cases then any cash flow that would be getting swept to amortization is instead getting returned to equity on a rolling basis instead of at the end. This should be accretive to IRR so long as your cost of equity > cost of debt. You are paying more total dollars in interest so your multiple will be lower.
The difference in multiple that you're describing leads me to believe you're doing something funky in the calc or that the loan terms are dramatically different.
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