What to Know Before You Refinance Commercial Property
When you refinance commercial property, you replace an existing mortgage with a new loan to lower your monthly payments, change loan terms, tap your property’s equity to make improvements or add new commercial properties to a growing portfolio.
Before you consider refinancing commercial real estate, though, it’s critical to understand the pros and cons of the process, as well as the various costs and lending requirements.
What does it mean to refinance commercial property?
In the real estate world, commercial property is a building or land that is used for business purposes. This includes office buildings, industrial properties or retail spaces. However, commercial property can also include multifamily housing like apartment buildings.
At its core, commercial real estate financing works similarly to residential mortgages. Refinancing a commercial loan is therefore very similar to refinancing a mortgage on a residential property: The process involves using the money from a new loan to pay off an existing one. Typically, borrowers refinance their loans when they can qualify for more favorable terms, such as a lower interest rate or a different loan type. Refinancing can also help property owners access the cash that their home equity represents, increasing cash flow.
Pros and cons of refinancing a commercial property
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 a loan amount, are an option for commercial loans. The reason is that commercial loans often have shorter repayment periods than traditional mortgages — usually five to 10 years — and are amortized over shorter periods, leaving a large payment left when the loan comes due. 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 commercial real estate 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 will outweigh the cost of any fees you’ll pay up front.
You may not be able to refinance all types of commercial property loans. The rules about which commercial property loans can be refinanced are complex and subject to change. Check in with your lender to see if your current loan program has any restrictions.
You could face a prepayment penalty from your former lender. Some lenders — including the U.S. Small Business Administration (SBA) — charge a prepayment penalty for paying off your loan early, which can add to your costs.
Commercial property refinance loan types
Here are the three main options to choose from when looking 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 U.S. Department of Agriculture (USDA). Both of these agencies back loans up to $5.5 million.
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 (fails to repay the loan). This guarantee makes it easier for lenders to offer borrowers flexible qualifying standards, which in turn makes these loans more accessible to more people.
Who’s eligible: In order to refinance into an SBA loan, you must have equity in your business and it must be a for-profit business of a suitable size operating in the United States. You’ll also have to show that you’ve been in operation for at least two years, as well as demonstrate that you can’t get funding elsewhere. 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. You can check your business’s location using the USDA’s property eligibility tool.
Conventional commercial refinance loans
What it is: A conventional loan is any mortgage that’s not backed by the federal government. Conventional commercial mortgages typically come from a traditional bank or mortgage lender. Commercial loans often don’t have specific loan limits; instead, lenders allow you to borrow a certain percentage of the value of the property that acts as collateral. They typically allow a loan-to-value (LTV) ratio of 60% to 80%. According to guidelines set by the Office of the Comptroller of the Currency, the maximum LTV ratio shouldn’t exceed 85%.
How it works: With this option, a borrower can switch to a loan with a different interest rate, a different type of interest (fixed versus adjustable) or a shorter loan term.
Who’s eligible: Typically, conventional commercial loans have stricter qualifying requirements than government-backed loans. You may face stricter credit score requirements, lower maximum LTV ratios and shorter loan terms (which means more expensive monthly payments that are more difficult to qualify for). Compared to SBA or USDA loans, conventional commercial loans are geared toward more established business owners who can meet these 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 can expect to access around 75% of the refinanced property’s value in cash.
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. Commercial lenders typically require you to have 30%-40% equity in the property before they’ll allow you to take cash out.
Commercial property refinance interest rates
Although the refinance rates you are offered will vary depending on the lender, your business’s attributes and your credit profile, you can expect to see the lowest rates with government-backed SBA and USDA loans, followed by conventional loans.
Requirements to refinance commercial property
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 nongovernment 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, not including debts and income taxes. As a rule of thumb, the greater the NOI, the better your chances are of a refinance commercial loan approval. NOI requirements 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 and 1.5 as a benchmark.
Operating history Lenders generally prefer to see at least a few years of a stable operating history in order to prove that the business is sustainable.
Closing costs and fees when refinancing a 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 check fee||$100 to $1,000|
|Application fee||Varies by lender|
|Origination fee||1% or more of the loan amount|
|Appraisal fee||$1,000 to $10,000|
→ 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 (aka upfront 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 check fee. Lenders pass the cost of checking your credit on to you, the borrower. This fee is nominal, usually ranging from $100 to $1,000.
→ 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 refinance 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 for a residential mortgage because the loan amounts are larger and the appraisal reports require more research and work. Commercial mortgage appraisals may range from $1,000 to $10,000, but as with all appraisals, the charges will vary based on location and other factors.