Disclaimer: I am not an attorney and this article is not intended as a substitute for advice from the appropriate legal, zoning, financial, construction and/or tax professionals. This information is provided for educational purposes only and is made without warranties or representations
Refinancing any type of property involves taking out a new loan that replaces your existing mortgage. While the process of refinancing is, at its core, the same between residential and commercial properties, there are some key differences when you start getting into the details.
In the recent past, low rates made it highly appealing to refinance in order to take advantage of lower monthly payments. As interest rates have been rising, more complicated calculations are required to determine if it’s worth the cost.
Whether you’re hoping to reduce your monthly expenses, switch to more favorable loan terms, tap into the equity of your property, or avoid hefty balloon payments, commercial owners have to weigh a number of factors before deciding to refinance in the current climate.
Let’s take a look at what you need to know about refinancing in a high-interest-rate environment as a commercial real estate investor.
Commercial real estate investors are motivated to utilize leverage in order to boost their returns. As the cost of borrowing goes up, potential returns go down. The more expensive it is for investors to borrow money in order to purchase existing properties or develop new ones, the less demand there is for new projects.
Essentially, higher interest rates increase the amount of risk an investor takes when they purchase or build a property. A project is only worth taking on if it is going to fit within the acceptable risk tolerance of an investor, and higher debt payments mean a lower ROI and higher risk.
Higher interest rates can also have a negative impact on property values. As investors start to get nervous about the cost of borrowing money, there’s less demand for existing properties and fewer new properties being built. While this can be disconcerting for some investors, others see it as an opportunity– as some owners decide to jump ship and sell, other investors hop in and snag properties at a bargain.
Other investors might respond to a high-interest rate environment by focusing on properties that typically generate more stable cash flow. For example, they might be motivated to keep their portfolio stacked with properties that are leased to high-quality, creditworthy tenants in desirable, in-demand areas. Additionally, investors might choose to focus on particular local markets that are more resilient to downturns and swings in the market.
Ultimately, refinancing is challenging in the near term for commercial property owners, but by no means impossible. The truth is that something of a perfect storm between continuing fears of a recession and rising interest rates has led banks to have tighter credit standards. Along with this, the quality of commercial real estate loans is being more closely monitored by regulators.
It’s worth noting that the current environment is more stable than those that led to the 2008 financial crisis, but that doesn’t mean that investors wouldn’t be wise to create a defense strategy and work to create a portfolio that will be resilient to bumps in the road.
Residential investors commonly use low-interest rate environments to refinance their properties. For commercial investors, things aren’t quite as straightforward. Commercial real estate has a number of qualities that make it unique from residential real estate, meaning that you can’t simply use the same logic to determine when to refinance.
One reason for this is that many commercial real estate loans will balloon in a period of years– typically 5, 7, or 10– rather than simply being fixed for thirty years. This means that CRE investors are motivated to refinance or sell their properties in many instances.
Another important distinction is that many CRE investors rely on cash-out refinances in order to come up with the capital to grow their portfolios. In a high-interest rate environment, whether to wait it out or tap into your equity despite the interest rate is up to you.
For many investors, waiting to refinance due to high-interest rates can mean missing out on a number of benefits of being a CRE investor, including tax benefits and the ability to grow their wealth as quickly and sustainably as possible. Ultimately, each investor has to run the numbers on refinancing in this environment versus the potential of facing a hefty balloon payment or dealing with unfavorable loan terms.
While there are many similarities between the way that residential mortgages and commercial real estate refinancing work, there are also important differences that could impact your decision regarding whether to refinance when interest rates are this high.
At its core, refinancing either a commercial property or a residential one entails taking on a new loan in order to pay off an existing loan. Investors might refinance in order to avoid balloon payments, get cash from their properties to expand their portfolios, or access more favorable terms.
Refinancing is most often discussed in relation to securing lower mortgage rates, but this might not be possible for you in the current interest rate environment. However, you still might find that it’s worth doing in order to get better loan terms, avoid a balloon payment, or access cash from your properties.
For instance, you might find that the savings justify the cost of refinancing, even with interest rates as high as they are, to either shorten or lengthen your loan term. On the other hand, your loan might have a large balloon payment that is coming due soon that you want to avoid, and refinancing is still the more cost-effective option.
If you’re interested in growing your portfolio, a cash-out refinance can make it possible to get your hands on the capital you need. Strategically using cash-out refinances is a method many real estate investors use to quickly and sustainably grow their wealth.
Refinancing simply isn’t a cheap process. There are closing costs associated with refinancing (just like when you bought the property in the first place) along with other fees. It’s also time-consuming, particularly for commercial real estate, a cost you’ll want to consider seriously before beginning the process.
On top of the cost of closing expenses, associated fees, and your time, you’ll also want to be aware of the potential for prepayment penalties for your current loan. If you pay off your loan early, you might get stuck with a surprise and unwelcome bill, so you’ll want to research this before making any moves.
Finally, there is also the potential that the type of commercial property you own can’t be refinanced. Talking to your current lender about restrictions on your current loan program can help you get a better sense of what your options are.
Before you make any moves, you will want to take a closer look at your current loan and your financial situation. Ensure you clearly understand the loan term, interest rate, and any potential prepayment penalties you could face.
From there, you’ll want to focus on your financial situation. How would refinancing in the current high-interest rate environment impact the financial performance of your property? By taking a look at your cash flow, occupancy rates, and other performance metrics, you can start to glean whether refinancing will be worth the trouble and the cost.
Another important piece of information when considering refinancing your commercial property is the asset’s current market value.
You can look at comparable properties that have recently sold, talk to a qualified real estate broker, or hire out an appraisal to better understand your property’s value.
Will higher rates lead to financial stress, or is it worth refinancing in the current environment?
How will refinancing with rates where they are impact your ability to cover debt services?
If you’re thinking about refinancing your commercial property, the last thing you’ll want to do is go with the first lender you come across.
There can be quite a bit of variation between lenders when it comes to the interest rates and terms they’re willing to offer you. By shopping around, you can find loan packages that best suit your needs. Furthermore, you can use competing quotes to try and negotiate a better deal with your lender of choice.
Would it be more advantageous to you to lock in your interest rate with a fixed-rate loan, or are you willing to take on an adjustable-rate loan? Are you motivated to try and shorten or lengthen your loan repayment term? Or do you want to tap into your equity so you can get the capital you need to buy another property and grow your portfolio?
There are typically three primary options when it comes to commercial property refinance loans. These are:
Government-backed refinance loans are backed by federal agencies like the U.S. Department of Agriculture or the Small Business Association. In the case of both of these examples, commercial loans can be backed up to $5.5 million.
Conventional commercial loans aren’t backed by the government– these usually come from a traditional mortgage lender or bank.
Unlike government-backed loans, there aren’t usually loan limits for conventional commercial loans. Instead, you can usually borrow a certain percentage of your loan-to-value ratio– typically 60% to 80%. This percentage of your property’s value acts as collateral.
Finally, there’s also the option to do a cash-out refinance. This lets you borrow more money than you actually owe on the asset in order to give you access to cash. At closing, you receive the difference between the loan amount and what you owe on the existing mortgage. For this type of loan, you can typically access about 75% of the value of the property.
In order to do a cash-out refinance on a commercial property, you usually need to have at least 30% or 40% equity built up in the property.
There are costs to refinancing, and whether or not it’s worth it for you to go through the trouble is going to depend on how these costs relate to the savings or benefits you expect to receive from the process.
When we think about refinancing, the most obvious costs are the closing costs associated with the deal. However, there are also going to be appraisal fees and potentially even prepayment penalties for the loan you currently have. It’s worth taking the time to carefully examine how these expenses will compare to any potential savings or benefits.
If you’ve decided that refinancing is worth it despite the current high-interest rates, the next step is to get your ducks in a row and assemble all of the financial documents you’ll need to make the process go smoothly.
This includes gathering financial statements, tax returns, property management reports, and lease agreements.
Working with a professional advisor when you’re refinancing can be well worth the cost– they’ll have the experience and knowledge to help you navigate the process.
There are multiple different factors to consider at once, and the help of a pro can ensure you don’t make a costly mistake along the way.
If this is your first time refinancing a commercial property, it’s worth noting that the process can be a lot more time-consuming and complicated than refinancing a residential property.
The reasons for this are manifold, including larger loan amounts, more complex transactions, customized loan terms, and legal and regulatory requirements.
Balloon mortgages are very common in commercial real estate, where investors make monthly payments for a period of time before a large, final payment comes due. As opposed to regular residential mortgages that are fully amortized, commercial real estate loans are often structured so that only a portion of the debt is amortized, and a lump sum will be due after a certain number of years.
If you’re facing a balloon payment for your commercial property, your options are generally to refinance, negotiate with the lender, or sell the property. In the current high-interest rate environment, weighing the pros and cons of refinancing is essential.
Are you wondering whether it’s actually more advantageous to sell your property than to refinance? If you’re a commercial real estate owner in California, let’s start a conversation today.
As always, if you ever have any questions about anything I discuss in my articles, please feel free to let me know, and I’ll do my best to help you out in any way I can!
Erik Egelko is a veteran of the commercial real estate business with a specialized focus on Investment Property Sales. In 2021 and 2022, Erik was the #1 ranked Broker in California for one of the largest CRE Firms as well as ranked in the Top 1% of brokers nationwide. He has extensive experience in a variety of asset types including: Retail Shopping Centers, Medical Office Buildings, Industrial Properties, and Multifamily Apartment Complexes. Over the course of his career, Erik has closed over $100,000,000 of commercial property sales throughout Southern California.