As entrepreneurs, we’re always ready to jump in.
This usually works out alright, but there’s a few times where it can come back to bite us.
I see that a lot in Commercial Real Estate lending, and here’s a few ways you can use refinancing to get out of a rut.
Types of Real Estate Loans
The first thing I wanted to cover was the different types of real estate loans.
Don’t get me wrong, trouble can happen with any loan – but the complexity of non-traditional loans usually leads to issues.
Traditional Term Loans
So with all of that being said, let’s start with the easy one first – traditional loans.
This type of loan is similar to a personal mortgage. There’s not too much complications with it, you simply get money and pay it back over an agreed upon amount of time.
This simplicity eliminates a lot of the concern, and really the only worry is having a fixed rate that’s going to be higher than future rates.
In other words, you close your loan during a time where interest rates are high – then years later you figure out you’re paying 3% above the current rates.
The same thing that happened with our recent refinance rush – where everybody wanted to get out of the 8% loans they closed when times were good.
Non-Traditional Term Loans
And then we have non-traditional term loans, or – any loan that doesn’t fit into the simple “traditional loan” bucket.
This term is vague and could be looked at in many ways, but for the purposes of this article – we’re only going to cover the common types.
And you’ve probably heard of them, they were another big topic during the 2008 Housing Crash.
But anyway, a balloon loan is simply a loan that matures with a balance. The “balloon” part comes from a one-time large payment that’s due when the note matures.
The biggest question with these type of loans is simply, why do we have them? What is the point of a maturing loan with a balance.
Well, there’s a few theories – but one things for sure, they’ve been cleaned up since the 08 crash.
Now they’re used for good reasons, like a forced “review period”. I touched on this a little bit earlier, but a big fear (for both parties) is getting locked into a rate that’ll hurt them in the near future.
So to combat this, they have periods of maturity where the note is technically due – but it’s really just a timeframe that forces both parties to review the current agreement and see if any changes need to be made.
And don’t take this the wrong way. It’s easy to assume that this is setup for their favor only, but that’s usually not the case.
There’s really only 2 times where you’ll be at trouble for this.
And that’s if you’re either A) In Financial Trouble, or B) Have a rate that’s way too low.
In situation A, you might have bigger problems and a restructuring of the loan is probably a blessing in disguise.
In situation B, well – that’s an obvious downside.
And that covers everything we need for now, if you’d like more information on this topic – then please visit our article, Beginner’s Guide to CRE.
How Refinancing Can Help
Alright, now that the story is set – it’s time to see how refinancing could help you.
Increased Cash Flow
This one is pretty self-explanatory, refinancing your current loan might put more cash in your pocket.
This always sounds like a good idea, and usually is – but there’s a few things you’ll want to look out for.
Let’s start with the good stuff.
A good form of increased cash flow could take place if you refinanced at a lower interest rate.
Lower rates = lower payments…meaning more cash in your pocket (and profit to your bottom line).
Another good example would be if you refinanced to do a “cash out” mortgage, or getting money from your existing equity to make payments.
It’s hard to find the term and interest rate that a Real Estate loan has to offer, making this a valuable option compared to other routes…
But that’s also where the irony comes in. Even though this method can be very useful, it can also be a red flag.
And that usually occurs when you need to refinance your mortgage just to make the payments smaller.
This wouldn’t be a cash out mortgage because no new money is taking place, meaning that the one goal is to decrease your payments.
And that sounds good on paper, but when you dig into it – you’ll realize that you’re only causing more (interest) expense on your financials – something you want to avoid…
But with all of that said, if it’s what you have to do to keep the doors open – then well, that’s what you got to do.
Moving on to the next section, refinancing for better terms.
This is always an interesting topic because it doesn’t happen THAT often, but when it does – the results are noticeable.
As I mentioned earlier, a lot of changes can happen during long-term loans…and there’s going to be a time where you wish a certain term or condition wasn’t holding you back.
In the industry, they call these loan covenants. And covenants is a broad term that can mean a lot of things, but the common ones that cause issues are:
- Debt Service Covenants (saying you’re debt service coverage has to be a certain ratio)
- Debt-to-Equity Covenants (saying you can have too much debt)
- Financial Reporting Requirements (making you submit financial statements at an agreed upon time)
And that’s before I even get into the collateral part of things. I guess technically that’s still a covenant, but cross-collateralization seems to be a big issue that drives refinancing.
It could be for anything, but it usually happens with an overzealous banker that ties all of your assets together. Protecting their loan at all costs.
It makes sense, until you’re trying to sell a building and the bank makes you jump through hoops to do so. Might have made sense at the time, but not so much now.
Peace of Mind
And the last topic really ties the top two together, but peace of mind is another driver of refinancing.
It could happen for many reasons, but you’re wanting to lock in different terms – because you know it’ll help you in the foreseeable future.
Like if you know interest rates are going to increase, or you know you’ll be selling a (cross-collateralized) building soon.
The current banker might not like the new deal, but that’s what other lenders are for.
Is Refinancing for You?
As we just talked about, refinancing can help in many different ways.
From lowered interest rates to peace of mind, there’s a great chance refinancing can help you.
BUT, that doesn’t mean it’s always easy – and that’s also why most people are hesitant to do it.
PLUS, you’ll always want to check everything before you do. A large prepayment penalty could quickly offset your savings.
The good news? We’ve handled this a time or two – and I’m more than willing to help you too.
Other questions and comments? Please let me know below!