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In this Ultimate Guide To Refinance Commercial Real Estate, you'll learn the advantages, disadvantages and requirements to refinance a commercial property.
The decision to refinance commercial real estate is important for owners and investors. Whether you want a lower interest rate, more cash or both, refinancing is one solution to maximize profit on a commercial real estate property.
Before you refinance commercial real estate, it’s important to understand the advantages and disadvantages. Here’s what you need to know about commercial real estate refinancing:
The process to refinance commercial real estate is comparable to refinancing residential real estate. When a commercial property owner refinances a mortgage, the owner borrows a new loan and uses the proceeds to pay off an existing mortgage. Typically, real estate owners refinance a commercial property to get a lower interest rate, change loan terms, or access cash from the existing equity in the property.
Commercial real estate includes office buildings, retail properties, multi-family housing, industrial properties, data centers and other real estate used for a business purpose. Apartment buildings with more than five tenants are considered commercial real estate even though tenants use the property for their personal residence.
Real estate owners can leverage several key advantages when they refinance commercial real estate. For example:
1. Get a lower interest rate. The best way to save money on a commercial mortgage is through mortgage refinancing. When you refinance a commercial mortgage, you can get a lower interest rate, which saves you money each month and increases cash flow.
2. Change type of interest rate. The macroeconomic environment may influence whether you prefer to have a fixed interest rate or a variable interest rate. A fixed interest rate means your interest rate will never change over the duration of your mortgage. In contrast, a variable interest rate means that the interest rate on your mortgage can change as underlying interest rates change. If interest rates are increasing, then it may be advantageous to refinance your existing mortgage with a fixed-rate loan. However, if interest rates are declining, it may be a better financial decision to refinance with a variable interest rate mortgage.
3. Change payment terms. Refinancing is also a helpful tool to get more favorable loan terms. For example, when you refinance your existing mortgage, you can choose new loan terms that may offer a shorter duration. While monthly payments will be higher, you’ll pay off your loan faster and save interest. If you prefer to maximize monthly cash flow, you could extend the duration of your mortgage. However, while monthly payments will be lower, you will pay higher overall interest over the life of your loan.
4. Access cash from existing equity. A cash-out refinance helps you access cash from the existing equity in your commercial property. Property owners and investors often use cash-out refinancings after making value-added improvements or renovations to a property. With a higher appraised value, an investor or owner can cash out a portion of the increased equity. When you complete a cash-out refinance, you may have a higher mortgage balance. However, you can use the cash proceeds to purchase other properties or reinvest in your current property. You also want to ensure that your monthly cash flow can satisfy your monthly debt requirements.
5. Extend debt maturities. In comparison to residential mortgages, commercial mortgages have shorter loan terms. While a residential mortgage could be 15-30 years, some commercial property loans may be five to 10 years, for example. This shorter duration loan means borrowers could have a large balloon payment due sooner. To avoid this outcome, borrowers can refinance to extend debt maturities. By restructuring their debt, they can extend their loan duration and push out the due date of the property’s underlying mortgage.
While there are several benefits to refinancing commercial real estate, borrowers should be knowledgeable about the disadvantages, which include:
1. Fees and closing costs. Like all commercial loans, refinancing includes fees and closing costs. You want to ensure that your new interest rate or loan terms outweigh the costs of refinancing your existing loan.
2. Prepayment penalty. Make sure your lender doesn’t charge a prepayment penalty for paying off your loan early. A refinance loan is considered a full repayment of your existing loan.
3. Slow process. Banks may have a slow approval process, which can delay the time required to refinance a commercial property.
Borrowers have several options to refinance commercial real estate loans, including:
What is a conventional refinance loan? A conventional refinance loan is a mortgage from a commercial lender such as a bank or mortgage lender that isn’t backed by the federal government. With a commercial mortgage loan, lenders allow borrowers to borrow a percentage of the appraised value of the property. For example, if a property is valued at $10 million, and the loan-to-value (LTV) is 70%, this means a borrower could borrow $7 million as a mortgage.
Eligibility: Banks and mortgage lenders are the primary sources of conventional refinance loans. These lenders may require financial information, credit scores, a shorter loan duration, and more limited LTV ratios. Newer commercial real estate investors may not be able to access as favorable loan terms as more established borrowers.
Loan features: Conventional refinance loans are similar to existing mortgages. Borrowers can get a lower interest rate, shorten or extend the duration of the loan, switch to a fixed interest rate or variable interest rate, or change other loan terms.
What is a government-backed refinance loan? A government-backed refinance loan is a private commercial loan that is backed by a federal government agency such as the U.S. Department of Agriculture (USDA) or U.S. Small Business Administration (SBA). Since the federal government backs these loans, there is less risk to a lender if the borrower defaults.
Eligibility: SBA loans often have owner-occupancy requirements and may have limits on company size to qualify as an eligible small business. USDA loans are available for commercial properties in rural areas. These loans also may require existing equity in the property, and an owner must have owned and operated the property for at least two years.
Loan features: Government-backed refinance loans are easier to qualify for than conventional refinance loans. The refinancing process is similar to refinancing conventional refinance loans.
What is a commercial cash-out refinance loan? A commercial cash-out refinance loan allows you to borrow a larger mortgage, pay off your existing mortgage, and keep the remaining cash proceeds. This cash is tax-free and can be used to upgrade your existing property, purchase a new property, or for other purposes.
Eligibility: To conduct a cash-out refinance, you need to have significant equity in your existing property. Typically, lenders expect at least 30% equity in your property to qualify for a cash-out refinance.
Loan features: Lenders may offer either fixed-rate or variable-rate cash-out refinance loans. Typically, a commercial real estate borrower can borrow approximately 75% of the appraised value of the property.
Each lender will have its own underwriting criteria to refinance a commercial mortgage. While requirements will vary by lender, here are some key requirements that many lenders will have:
Credit score requirements may vary by lender. For government-backed loans, such as an SBA loan, a business credit score of at least 155 (out of 300) is required.
Net Operating Income
Lenders will evaluate your Net Operating Income (NOI) to understand how much cash the property generates. NOI is equal to a property’s gross income less operating expenses. A real estate owner with a higher NOI property generally has a higher chance of approval to refinance a commercial mortgage.
Lenders want to evaluate books, records and two years of tax returns. The goal is to assess the financial performance and stability of the property.
Traditional lenders will require a new, third-party appraisal to assess the latest, fair market value of the property.
Lenders will evaluate the property’s cash flow to determine how much cash flow can be applied for debt service. A higher debt service coverage ratio (DSCR) provides a lender with more confidence that the mortgage will be repaid.
Commercial real estate refinancing fees
When you refinance commercial real estate, you should expect to pay multiple fees, which could include: