What Is a Commercial Real Estate Refinance? How Does It Work?

At its core, a commercial real estate refinance involves taking out a new loan to pay off an existing one. Investors often use refinancing as a method to secure better loan terms. With that in mind, here’s a guide to the commercial refinancing process. You’ll learn about when it makes sense to refinance, eligibility requirements you might face, and tips on how to find the best loan program for you.

Why would an investor consider a commercial real estate refinance?

Now that you have a better idea of what a commercial real estate refinance is, the next step is to take a look at the reasons why someone might want to refinance their commercial loan. Truthfully, there are many benefits to making this financial move, such as the following.

Avoiding balloon payments

Commercial loans mature much faster than residential mortgages. While these loans still amortize over a period of 25 years, most come due within only a few years of making small, incremental payments. While the average loan term on a residential mortgage is 30 years, on a commercial loan the loan term might only be two, five, or 10 years.

At the end of the loan term, a balloon payment for the remainder of the loan amount is usually required. As you might be able to guess, a balloon payment is a large lump-sum payment for the remainder of the loan.

However, property owners can avoid having to make this payment if they refinance the loan before the balloon payment comes due.

Taking cash out for improvements

Another reason why someone might decide to refinance their property is to leverage the equity they’ve built up in order to fund improvements. This is done using what’s known as a cash-out refinance. As the name suggests, you can borrow more money than you owe on the property. In this case, the difference between what you’ve borrowed and what you owe is given to you as funds, which you can use however you see fit.

Many investors choose to use these funds to make improvements to the property. The thinking behind this is that when they’re done making improvements, they’ll be able to charge the tenants higher rent, increasing their profits.

Securing a better interest rate or loan terms

Lastly, some investors might choose to refinance in order to secure a better interest rate or more favorable loan terms. Though commercial financing is often subject to higher interest rates than residential loans, refinancing when rates are low can help you lower your monthly payment, which will increase your cash flow.

It’s also possible to refinance in order to secure better loan terms. Many commercial loans have an adjustable interest rate. If rates are rising, an investor might choose to refinance into a fixed-rate loan option to provide greater stability. In addition, many commercial loans also come with a prepayment penalty, so an investor might want to refinance into a loan without this penalty.

What are the eligibility requirements for a CRE refinance?

Next, it’s important to consider the eligibility requirements for refinancing a commercial real estate loan. The requirements are much different than what you might expect to see with a traditional mortgage.

Net operating income (NOI)

In the world of residential mortgage loans, the borrower’s income and personal credit score are usually two of the biggest determining factors in whether they get approved. For commercial real estate owners, however, the biggest determining factor is usually the building’s net operating income (NOI).

Net operating income is a measure of the income generated by the property, less its operating expenses. For the lender, a strong NOI proves the investor has enough income regularly coming in to sufficiently cover the loan payments. In general, the higher your NOI, the better the loan terms you’ll receive.

Debt service coverage ratio (DSCR)

Another equation lenders look to when approving you for a business loan is your debt service coverage ratio (DSCR). This calculation is rather simple. All you need to do is take the company’s annual net operating income and divide it by its total annual debt payments. In short, looking at this equation tells commercial lenders if the company can afford to take on any more debt at the moment.

Business credit score

Finally, commercial lenders also look at the company’s business credit score. Three agencies produce the most widely used business credit scores: Dun & Bradstreet (NYSE: DNB), Experian (LSE: EXPN), and FICO (NYSE: FICO). Notably, while Dun & Bradstreet and Experian use a score rated from 0 to 100, FICO uses its own scoring method, which ranges from 0 to 300.

Generally, the higher your business credit score, the better the loan terms you’ll receive. That said, if you’re personally guaranteeing the loan, you may also need to allow the lender to pull your personal credit for review.

Tips for successfully refinancing a commercial loan

Ultimately, the first step in refinancing your commercial real estate loan is to find a lender that is the best fit for you. With that in mind, here are tips on how to best proceed.

Look into an SBA 504 Debt Refinancing Program

The SBA 504 Debt Refinancing program works similarly to taking out an FHA or VA loan for your residential property. Here, the Small Business Association reduces the lender’s risk by agreeing to guarantee a large portion of the loan if you default. Using this loan program, borrowers are eligible to refinance up to 90% of the property’s value.

There’s also the option to roll some eligible business expenses into the loan. However, at that point, your eligible loan-to-value ratio would drop to 75%.

Shop around for a lender

If you’re not a good fit for the SBA’s refinancing program, it’s a good idea to compare lenders. Just like with residential mortgages, commercial lenders all have their own fee structures. Some charge an origination fee, expressed as a percentage of the refinancing package, for example. You’ll want to make sure you understand and feel comfortable with any fees you’re being charged.

Make sure you understand the closing costs

Lastly, in addition to lender’s fees, make sure you understand all the closing costs you’ll encounter. Traditionally, commercial closing costs are much more than when refinancing a residential loan. For instance, an appraisal for a commercial loan is usually thousands of dollars rather than hundreds.

To that end, talk to your lender to get an estimate of these costs before you apply for the loan. It may also help to calculate your break-even point, which will tell you how long it will take to recoup the upfront cost of closing on a new loan from the savings the new loan provides.

The bottom line

Though refinancing a commercial real estate loan is different from refinancing a residential loan, in many respects, at their core, the benefits are the same. Refinancing is all about lowering your monthly payment, securing better loan terms, or leveraging the equity you’ve built up in the property to pay for a big expense.

With that in mind, if you think refinancing your CRE loan might be right for you, use this as your guide to the process. Armed with this knowledge, you should have a foundational knowledge of what the commercial refinancing process entails.

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