It’s no secret that most homeowners have refinanced their home mortgage at least once, if not more than once, over the past five years. (If you’re reading this and haven’t refinanced your home mortgage in the past five years, you should call your bank to explore your options.) This can be largely attributed to one factor: record low interest rates. Interest rates almost exclusively drive the refinance market for homeowners. In fact, since 2010, the refinance market has accounted for 60-plus percent of the total residential mortgage market.
Unfortunately, the same can’t be said for the commercial real estate market. While declining or low interest rates will certainly dictate some commercial mortgage refinance activity, low rates may not be the primary indicator for refinancing your commercial mortgage.
When is it time to consider refinancing a commercial mortgage?
The following may not be all-inclusive, but these are the most common indicators that it’s time to consider refinancing your commercial mortgage that I’ve seen in my 20-plus years as a lender.
- Balloon payment due within a year: Unlike residential mortgages, most commercial mortgages are not fully amortizing loans—they have a maturity or balloon payment that is due well before the amortization ends. If you have a balloon payment coming due, you will want to refinance into a new loan to avoid that potentially large liability.
- Lower interest rate: The typical rule of thumb for residential mortgages is that if you can reduce your interest rate by 0.75 to 1 percent or greater, then it might make sense to refinance. The same cannot be said for commercial mortgage refinancing. Generally speaking, rates have to have fallen by greater than 2 percent (all things being equal) to even think about refinancing. The expenses involved in refinancing and closing a commercial mortgage are far greater than with a residential mortgage.
What are the expenses to expect when refinancing a commercial mortgage?
- Prepayment penalty: Does your current mortgage have a prepayment or defeasance penalty? Most fixed-rate commercial mortgages do—you will need to speak to your lender about the penalty amount, and brace yourself, they can be substantial.
- Closing costs and related expenses: Most commercial mortgage refinances will require some type of appraisal and environmental report. You will incur your attorney fees, as well as the lenders’ attorney fees. There may be a mortgage tax (or mortgage assignment fee) associated with refinancing, particularly if you utilize a different lender. Closing costs can accumulate anywhere from 1 to 3 percent of the mortgage amount, so tread carefully when refinancing your commercial mortgage just because rates have fallen!
- **Here’s where you need to consider whether to go with a loan from your existing lender, which may have lower third-party fees, or whether a competing lender is willing to offer you a deal with lower fees in order to win your business.
- Freeing up cash flow or extracting equity from your property: Commercial real estate investors will often refinance their existing commercial property to extract equity (cash out) or lengthen the amortization on their mortgage to free up cash flow (monthly P&I payment decreases). Common reasons for doing so include reinvesting the cash-out proceeds into purchasing a new property or rehabbing your existing property. By extending the amortization, investors may see a reduced monthly principal and interest payment, thereby realizing a stronger cash flow. Understand that by extending the amortization, you may ultimately pay more interest to the lender.
Lastly, do your homework before you approach a lender about refinancing your commercial mortgage. Are your leases current? Does your property cash flow? Generally, lenders will want to see cash flow to cover debt service of approximately 1.2:1. Lenders will require two to three years of financial statements and/or tax returns on both the real estate holding company and the guarantors—yes, most commercial mortgages will require some level of a personal guaranty.
Peter VanPutte is the Managing Director of TBG Commercial Capital Partners, LLC.