Interest-only or amortizing: which apartment loan gets you more cash out.

Every long-term apartment loan has a coverage test. The building's net operating income has to cover the annual loan payment by a set ratio, often 1.25 times. Divide the income by 1.25 and you get the most the building can pay each year. The loan amount is whatever that payment supports.

That's the whole story. An amortizing payment includes interest and principal. An interest-only payment is interest alone. Because the interest-only payment on the same loan amount is smaller, the same annual payment carries a bigger loan.

The rate doesn't change the logic. The value doesn't change it either, as long as the loan stays under the maximum LTV. The only thing that changes is how much of each payment goes to principal, and on an interest-only loan, that's zero.

Here's a stabilized 140 unit garden-style building:

• Net operating income: $1,330,000 a year
• Value: about $20.5 million, at a 6.5% cap rate
• Coverage requirement: 1.25x
• Rate: 7% for both loans, to keep the comparison clean

The most the building can pay each year is $1,330,000 divided by 1.25, which is $1,064,000.

On a 30 year amortizing loan, $1,064,000 a year in payments supports about $13.3 million.

On an interest-only loan, $1,064,000 a year is 7% interest on about $15.2 million.

That's a difference of about $1.87 million, from the same building, the same income, and the same rate. At 75% of value, the building could support up to about $15.3 million, so the interest-only loan uses almost all of the available leverage. The amortizing loan leaves about $2 million of it on the table because the coverage test stops it first.

The monthly payment is nearly the same on both, about $88,500. The difference is what the payment buys. On the amortizing loan, part of every payment pays down the balance. On the interest-only loan, none of it does.

Interest-only isn't free money. It's money now instead of equity later.

On the amortizing loan above, the balance drops from $13.3 million to about $12.5 million over five years. That's roughly $780,000 of equity built through the payments alone. On the interest-only loan, the balance after five years is still $15.2 million.

If you sell or refinance in year five, you'll have the same building and a bigger balance to pay off. Whether that matters depends on what you did with the extra $1.87 million. If it went into another building, a renovation that pushed rents, or paying off higher-rate debt, the math usually works in your favor. If it sat in a bank account, it probably doesn't.

There's also the end of the interest-only period to plan for. Some interest-only loans run interest-only for the full term. Others switch to amortizing payments after two, three, or five years, and the payment goes up when they do. Know which one you have before you sign.

• You want the cash out. The extra proceeds are the whole point. Owners pulling equity to buy the next building get the most from interest-only.
• The building is still climbing. If occupancy is in the high 80s or rents are still moving up, interest-only keeps the payment low while the income catches up. Our Apartment Loans Under 90% Occupancy page covers that situation.
• You're coming off a bridge loan. After a renovation and lease-up, the bridge balance is often more than an amortizing loan supports. Interest-only can close that gap without bringing cash to the closing.
• You plan to sell or refinance inside the term. If you're holding five to seven years, principal paydown matters less than proceeds today.

• You're holding for the long run. Paying the loan down over 30 years builds equity every month, and a 30 year fixed takes refinancing off the table entirely.
• You don't need the extra cash. If the amortizing loan already pays off your current debt and gets you the cash you want, there's no reason to take on a bigger balance.
• You want the lowest risk. A smaller balance with principal paydown gives you more room if rents soften or expenses jump.

Some owners split the difference: interest-only for the first two or three years, then amortizing. That keeps the payment low during the early years, when the building or the new acquisition needs the cash most, and starts building equity after that.