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What to Know Before You Refinance Commercial Property
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When you refinance commercial property, you’ll use the funds from a new loan to pay off your existing commercial mortgage. Commercial property owners might refinance to lower their monthly payments, change their loan terms or tap their property’s equity to make improvements or add new commercial properties to a growing portfolio.
Before refinancing commercial real estate, though, it’s critical to understand the benefits and risks of the process, as well as the various costs and lending requirements.
What does it mean to refinance commercial property?
In real estate, commercial property is real property that houses businesses used to generate income. This includes office buildings, industrial properties or retail spaces. However, commercial property can also include large residential apartment buildings.
Pros and cons of a commercial property refinance
You may be able to lower your monthly payment. The main reason why people choose to refinance is to lower their monthly payments. Typically, this can be done by securing a lower mortgage rate than you have on your current loan.
You might get better loan terms. Shortening or lengthening the loan repayment term or type of loan can also be beneficial if you own commercial real estate. For example, if you currently have an adjustable-rate loan, refinancing into a fixed-rate loan may help provide more stability in your payments if rates were to go up.
You might avoid a hefty balloon payment. Balloon payments, which are large, lump-sum payments for the remainder of the loan amount, are an option for commercial loans. The reason: Commercial loans have shorter repayment periods than traditional mortgages — usually five to 25 years compared with 30 years for a residential mortgage. Refinancing commercial real estate can help you avoid making such a big payment at one time.
You can borrow money tax-free with a cash-out refinance. With a cash-out refinance on a commercial property loan, you borrow more money than you currently owe and get the difference between the two loan amounts in cash. Many CRE investors use the cash to either make improvements to the property or buy new Investment properties.
You’ll pay hefty upfront costs. Just like when you took out your loan the first time, refinancing a commercial property will come with closing costs. Make sure that the savings from your new loan outweigh the cost of any fees you’ll pay upfront.
You may not be able to refinance all types of commercial property loans. At this time, existing U.S. Small Business Administration (SBA) 504 loans, which are backed by the U.S. government, cannot be refinanced. Check in with your lender to see if your current loan program has similar restrictions.
You could face a prepayment penalty from your former lender: Some lenders — including the SBA — charge a prepayment penalty for paying off your loan early, which can add to your costs.
Commercial property refinance loan types
Now that you know a little bit more about the benefits and disadvantages of refinancing a commercial loan, the next step is to learn about different types of refinance programs.
Here are the three main options to choose from when trying to refinance a commercial loan.
Government-backed refinance loans
What it is: This type of refinance loan is backed by a government agency like the SBA or the USDA. The SBA backs loans up to $5.5 million, as does the U.S. Department of Agriculture (USDA).
How it works: The refinancing process works like any other, except in this case, the SBA and USDA agree to guarantee a portion of the loan amount if the borrower defaults, which means they fail to repay it. This guarantee makes it easier for lenders to offer borrowers more flexible qualifying standards.
Who’s eligible: In order to refinance into an SBA loan, you must have a documented on-time payment history for the last 36 months. Notably, you may be denied for an SBA loan refinance if you do so for a reason the SBA deems ineligible, such as avoiding a balloon payment. For a USDA loan, the business must be located in a rural area and the business owner must be a U.S. citizen or have permanent residency status.
Conventional commercial refinance loans
What it is: A conventional loan is any mortgage that’s not backed by the federal government. Conventional commercial mortgages are the most common type of commercial refi loan, and typically comes from a traditional bank or mortgage lender. While commercial loans don’t have specific loan limits, lenders typically allow you to borrow a certain percentage of the value of the property that acts as collateral. They typically allow a loan-to-value ratio of 65% to 75%.
How it works: With this option, the loan terms are usually similar to those of the original loan, except for a different interest rate, type of interest (fixed versus adjustable) or loan term.
Who’s eligible: Typically, conventional commercial lenders have stricter qualifying requirements, including larger collateral requirements, a demonstrated ability to repay their debts and significant time in business. Conventional commercial loans are geared toward more established business owners who can meet the more stringent borrowing requirements.
Commercial cash-out refinance loans
What it is: A cash-out refinance commercial loan allows you to replace your existing mortgage with a new one by borrowing more money than you currently owe on the property.
How it works: Once you’re approved for a cash-out refinance commercial loan, the difference between the new loan amount and how much you owe on the property is paid to you, in cash, at closing. You may be able to use the cash as you see fit, though some lenders restrict the use of funds.
Who’s eligible: This type of refinance loan is best suited for those who have built up a substantial amount of equity in the property. For example, commercial lender CommercialRealEstate.loans requires at least 25% equity.
Commercial real estate refinance requirements
Once you’re aware of which type of commercial loan you need, it’s important to get a sense of the requirements for refinancing. Here’s an overview of some key guidelines:
Credit score. A business credit score is different from a personal FICO credit score. In general, lenders look for this score to be as high as possible. The SBA generally looks for a minimum FICO Small Business Scoring Service (SBSS) score of 155 (out of 300) in order to approve someone for an SBA 7(a) loan, but there may be exceptions. For a non-government loan, credit score requirements vary by lender.
Net operating income (NOI). Net operating income is a measure of a property’s gross income minus its operating expenses, except for debt service. As a rule of thumb, the greater the NOI, the better your chances are of a refinance commercial loan approval. NOI will vary by lender and loan program, depending on the type of business and the size of the property.
Debt service coverage ratio (DSCR). In real estate, DSCR is a measure of the cash flow that a business has available to pay its debts. In this equation, getting a ratio greater than one indicates that the company is generating enough revenue to cover its debts, so lenders usually look toward a range between 1.2-1.5 as a benchmark. For example, the Commercial Lending Center of America requires a DSCR of at least 1.25 for its Banc Series commercial loan program.
Operating history. Lenders generally prefer to see a few years of a stable operating history in order to prove that the business is sustainable. For instance, the Commercial Acceleration Loan Fund with the Ohio Development Services Agency requires a two-year operating history.
Business and personal documentation. The exact documents needed to refinance will vary by lender, but expect to show business and personal tax returns, bank statements for your business and personal accounts, year-to-date business operating statements, a schedule of commercial real estate holdings and the rent roll.
Fees and costs to refinance commercial property
Before you refinance commercial property, understanding the refinance costs involved can help you decide if it’s worth the effort. Here are a few of the most common closing costs that borrowers face when refinancing commercial real estate:
|Prepayment penalty||Varies by lender|
|Guaranty fee||0.25% to 3.75%|
|Credit report fee||$50 to $150|
|Application fee||Varies by lender|
|Origination fee||1% or more of the loan amount|
|Appraisal fee||$2,000 to $4,000+|
Prepayment penalties. Some lenders charge a penalty fee if you try to pay off your loan early. This fee is used to make up for missed interest payments. On an SBA 7(a) loan, for example, the fee is 5% of the amount of prepayment if you pay your loan within the first year. However, after that, the fee decreases.
Guaranty fee. The SBA charges a fee of 0.25% to 3.75% for backing your loan, and lenders pass this cost onto you. It varies by loan type and amount, but you’ll only have to pay it on the portion of the loan amount that the SBA is backing.
Credit report fee. Lenders typically pull your credit reports from the three major credit reporting agencies — Equifax, Experian and TransUnion — and pass the cost to you, the borrower. This fee is nominal, usually ranging from $50 to $150.
Application fee. Some commercial real estate lenders charge a fee to cover the costs of processing your loan application. You’ll have to pay this fee whether or not your loan is ultimately approved. For a commercial loan, this fee will vary by lender.
Origination fee. Many lenders charge a fee to offset the costs of completing your loan refinance. Rather than being a flat fee, the origination fee is expressed as a percentage of the loan amount and varies by lender. Generally, commercial mortgage refi borrowers can expect to pay 1% or more of the loan amount in origination fees.
Appraisal fee. You’ll need to pay a commercial real estate appraiser who will estimate the cost of the property that you intend to refinance. This fee is much higher for a commercial loan than a residential mortgage because the loan amounts are larger and the appraisal reports require more research and work. Commercial mortgage appraisals may range from $2,000 to $4,000, but charges will vary based on location and other factors.
FAQs about refinancing commercial real estate
How are commercial refinance rates?
In 2020, the average interest rate on a commercial mortgage refinance loan ranged between 3% and 12%. However, your specific rate depends on the type of loan that you choose, your qualifications as a borrower and the type of property being refinanced.
Can you do a cash-out refinance on a commercial property?
Yes, it’s possible to do a cash-out refinance on a commercial loan. Commercial lenders allow borrowers to cash-out up to 75% of the property’s current valuation. This method is a solid option for business owners who want to tap their equity and use the cash to make substantial improvements to the property or to add more properties to their portfolio.
What lenders will refinance commercial property?
The SBA and USDA, along with national banks, online lenders and credit unions all offer commercial real estate refinance options. Not all lenders offer the same loan programs, so shop around with at least three to five different companies to find the loan that works best for you.
Who should consider refinancing commercial real estate?
Consider refinancing commercial real estate if you think you may be able to get a better interest rate, if you need to change your loan terms or if you want to leverage the equity you’ve built in the property.