Although bankers sounded a bit more optimistic about the commercial real estate market during the second quarter, more than half of the $1.4 trillion in commercial mortgages coming due nationwide in the next five years are underwater and many banks are refusing to renew the loans.
Owners who purchased property at the peak of the market in 2005 or 2006 face the biggest challenge, because commercial property values have since declined by almost 35 percent. Now, they must refinance to deal with looming balloon payments, but few owners can meet today’s stringent underwriting criteria.
“Roughly 90 percent of commercial mortgages require a balloon payment after five years,” says Vincent Shin, first vice president and manager of the South Regional Underwriting Center for Wilshire State Bank. “So owners may need to consider creative financing options to avoid a short sale or foreclosure.”
Smart Business spoke with Shin about refinancing options for commercial mortgage holders.
How has the underwriting criteria changed for commercial property loans?
Prior to 2008, banks considered the underlying equity when evaluating an application for a commercial property loan. Now they’re scrutinizing the underlying cash flow of the business for owner-occupied properties, at a time when many businesses are struggling to turn a profit. In fact, you could say that cash is king. And while bankers used to accept a debt service coverage ratio (DSCR) of 1.0, bankers now want a DSCR of 1.25. To give you an example of the impact, a business owner now needs monthly cash flow of $12,500 instead of $10,000 to qualify for a $10,000 loan payment. Compounding the problem, banks are requiring loan-to-value ratios ranging from 40 percent to 50 percent and high occupancy rates for tenant-occupied buildings.
How can business owners evaluate their situation?
Work with your CPA to determine your debt service ability, so you have a general idea whether you can qualify for a new loan. Do everything possible to boost your company’s cash flow or fill your building with quality tenants by granting temporary rent reductions or improving the property. Then, talk to the current note holder to gauge their appetite for refinancing your existing mortgage. Your current lender will know the state of the marketplace and the approximate value of your property and should help you find a solution to your problem, because the lender has the most to lose if you default or request a short sale.
What are the best refinancing options?
For owner-occupied buildings with outstanding loans of less than $2 million, an SBA loan is your best option. Owners of tenant-occupied buildings should shop around for a deal, because each bank has its own risk tolerance and loan portfolio that influence their desire and willingness to write new mortgages. Drive a hard bargain if your business is flush with cash and use a possible short sale or foreclosure as a bargaining chip to motivate your current lender.
What should owners do if they can’t refinance their commercial property loan?
Beyond a short sale or default, consider these options if you’re facing an upcoming balloon payment.
- Partial principal forgiveness. Some banks may be willing to reduce your loan principal to avoid a short sale or foreclosure.
- Second property. Consider mortgaging another piece of real estate with a lower loan-to-value ratio to pay off or reduce your current loan.
- Offer additional collateral. Sweeten the deal by pledging a second property or offering the bank additional assets or accounts.
- Bifurcated loan. Consider splitting the current loan into two parts and refinancing a smaller primary loan that satisfies the desired loan-to-value ratio. Then, finance the remaining indebtedness under a second deed of trust. For example, if the current property loan is $1.5 million, refinance $1 million through a traditional loan and immediately apply for a secondary loan to secure the remaining $500,000. The secondary loan will probably require a balloon payment down the road.
- Private equity. Refinance through a private equity loan.
- Add partners or investors. Consider bringing in an additional business partner or investor who could provide an injection of cash to reduce the loan principal.
- CRA loan. The Community Reinvestment Act (CRA) was enacted by Congress in 1977 to encourage federally insured banking institutions to help meet the credit needs of their communities, including those of lower-income areas. A building must be owner-occupied to qualify.
Do you have any other tips for business owners facing a balloon payment?
First, start the refinancing process at least six to 12 months before your balloon payment comes due so you can shop the market and improve your company’s cash flow. Use the ramp-up period to clean up your credit report, acquire new customers or tenants or sell an underperforming business unit. Author a business plan, sales forecast and personal profile, because prospective bankers want to see how you intend to pay for the loan. Finally, consider a variety of refinancing options. Owners need to be creative to survive in our current economy.
Vincent Shin is the first vice president and manager of the South Regional Underwriting Center for Wilshire State Bank. Reach him at email@example.com or (562) 345-3102.