In business, there are many reasons why you may want — or need — to look into commercial mortgage refinancing. Maybe your credit score has vastly improved over the last few years and you’re hoping to score a better interest rate, or maybe you’re trying to avoid making a large balloon payment at the end of your current loan term. Regardless of your reasons for wanting to consider a new loan, the process can seem daunting. However, it doesn’t have to be. This guide will walk you through the ins and outs of refinancing a commercial mortgage so that you can make the financing decisions that will work best for you and your business.
Why refinance a commercial loan?
Lower interest rates
The first reason why you may want to refinance a commercial mortgage is to take advantage of lower interest rates. Interest rates are still at relative lows, historically, and if your financial situation has improved since the last time you were approved for a loan, you could be a candidate to take advantage of those lower rates.
Increased cash flow
The main benefit of those lower interest rates is that you’ll have a decreased monthly payment. That lower payment means increased savings, which can be a source of greater cash flow.
On the other hand, you also have the option of doing a cash-out refinance, in which you borrow more money than you currently owe. The excess comes to you as tax-free funds to be used however you wish. Usually, people use this method to undertake big projects like making improvements to the property or funding an expansion.
Better loan terms
Another reason why someone might consider refinancing is to create an opportunity to negotiate more favorable loan terms. This could mean moving from an adjustable-rate mortgage (ARM) to a more stable fixed-rate option or simply tailoring the length of the loan to meet your current needs.
Avoiding balloon payments
Additionally, refinancing your loan could be a way to avoid having to make a sizable balloon payment — a larger-than-usual one-time payment at the end of the loan’s term. Mortgages with balloon payments generally come with lower, sometimes interest-only, payments over the life of the loan. However, when the balance of the loan becomes due, it could amount to thousands of dollars. If you don’t have that amount of cash on hand, refinancing will allow you to extend your repayment window.
What are the borrower requirements to refinance?
In order to get approved for a commercial mortgage, you’ll need to meet certain borrower requirements. Though the exact specifications will vary by lending institution, here’s a general overview of what you can expect:
First and foremost, lenders want see that you have the ability to actually repay the loan. Typically, this is determined by something called a Debt Service Coverage Ratio (DSCR). It’s found by dividing your business’s net operating income by annual loan payments. In this case, it’s best to shoot for a ratio of 1.2 or more.
Ideally, your business will have a strong management history in order to prove its longevity. For this reason, most lenders limit themselves to businesses that have been operating for two years or more. You may also be asked to show a resume or business plan detailing your experience and future projections.
In this case, equity refers to the stake that the owner has in the property. In some instances in which the property generates enough income on its own, it can serve as its own collateral. In others, the borrower must put up personal collateral of his or her own.
Finally, lenders want to be sure that you have a history of paying off existing debts, so they’ll check your credit score. Be aware that both your business and personal scores may be evaluated.
How does a commercial refinance differ from a home loan refinance?
“Lenders look at this type of loan differently,” said James Hoopes, a senior vice president at NorthMarq Capital in Minneapolis, Minnesota.
“With home loans, your personal credit decides whether or not you get the loan. Here, the amount of income the property produces from its tenants is just as — if not more — important than your credit score.”
In addition to differences in qualifying requirements, Hoopes pointed out that there are huge differences in the way residential and commercial loans get paid off.
“Residential loans tend to amortize over the life of the loan,” he explained, “meaning that the homeowners will have usually paid off the loan in full by the end of the term.”
“Commercial loans, on the other hand, tend to have an amortization period that’s longer than the loan term, which means that borrowers can find themselves facing a large payment when the loan comes due.”
Above all, Hoopes cautions borrowers to think carefully before refinancing their commercial loans. These types of loans come with high penalties that aren’t seen when refinancing traditional home loans.
Types of commercial loans
These days, there are a few distinct types of commercial loans that you can choose from. Be sure to research each one before applying so that you know which type of financing is best for your business.
SBA 7(a) loans
The SBA 7(a) loan is the most common type of small-business loan. The loan is popular because it’s backed by the U.S. Small Business Administration (SBA) and is geared toward serving businesses that might otherwise be turned down by banks. These loans come with a limit of $5 million, and the SBA agrees to back up to 85% of loans up to $150,000 and 75% of those above that amount.
CDC/SBA 504 loans
Another government-backed loan, the CDC/SBA 504 loan is different from the SBA 7(a) loan in the way it’s structured. For this, the SBA will provide 40% of the total project costs, while a Certified Development Company (CDC) will provide an additional 50%, and your down payment will account for the final 10%. Due to its structure, there is no limit on how much you can borrow for CDC/SBA 504 loans; however, the maximum amount that the SBA will provide is $5 million.
Private loans are offered by a bank or mortgage company. Traditionally, these loans offer competitively low interest rates. In exchange, however, they typically come with higher qualifying standards in terms of acceptable credit scores and operating histories.
How can you find a lender?
Ideally, you’ll already have a lender in place from the last time you applied for a mortgage. However, if that’s not the case, don’t hesitate to do your own research. Ask your industry contacts who they use for financing, use the SBA website’s free lender match service and read online reviews.
The commercial loan refinancing process
“The first step to refinancing a commercial loan is figuring out what kind of loan you need,” advised Hoopes of NorthMarq Capital. This means taking a close look at why you want to refinance, whether it’s to secure a lower interest rate or to fund renovations via a cash-out option.
The next step is to shop around. “Talk to different lenders in your area to get a sense of what they can offer you. Ask about interest rates, fees and other terms until you find the best proposal for you,” he continued.
From there, it’s all about gathering the right documentation and filling out an application. Every lending institution will have different application requirements. However, in general, you should expect to need the following: a property description, a rent roll, proof of income (profit/loss or revenue/expense statements showing several years of operating history) and the borrower’s resume and financial statements.
“After that, you can enter what’s known as the underwriting period,” Hoopes said. “During this time, the lender will order an appraisal and other third-party reports to determine if you’re eligible to receive the loan.”
“Once the loan has been approved, the lender will issue a loan commitment and, at that point, it’s just a matter of preparing the legal documents for closing,” he concluded.
Fees and closing costs
Not surprisingly, fees can vary from lender to lender, as well; however, two common fees that you should watch out for are prepayment penalties and and a guaranty fee. Prepayment penalties can be hefty and result from paying off your existing mortgage early with your new loan.
For their part, only SBA loans are subject to the guaranty fee. This fee is charged to the lender but is passed along to you for the security of having a government-backed loan. Only the amount of the loan that’s backed by the SBA is taxed, rather than the loan’s face value.
Luckily, closing costs are a bit more predictable. “As a rule of thumb, for loans under $10 million, I would estimate 2% of the loan amount for both closing costs and lender fees, not including legal fees,” Hoopes said. “But they can move up from there.”
The bottom line
At first glance, commercial mortgage refinancing can seem like an overwhelming process, but it doesn’t have to be. With a little bit of research, planning and forethought, you should be able to find a commercial loan that serves your and your business’s needs.