When it comes to arranging financing for the acquisition of commercial real estate, many borrowers are immediately struck by how different the process is when compared to residential real estate lending. That difference is due, at least in part, to the fact that commercial real estate loans, unlike the vast majority of residential mortgages, are not ordinarily backed by any government entity, such as Fannie Mae or Freddie Mac.
Commercial real estate rates tend, therefore, to be somewhat higher and many banks and commercial lenders want to scrutinize not only the details of the real estate purchase, but the underlying business itself. One issue that is surely to come up: Fixed or floating rates? Which is best for commercial real estate? As with many situations, the devil is in the details.
Fixed-Rate Commercial Mortgages
Many commercial enterprises are drawn to fixed-rate mortgages because the risk is easier to calculate and the number of variables is somewhat less. The primary advantage to fixed-rate financing, of course, is the lack of volatility. It is easier to budget the cash outflow. Depending upon the situation, the fixed-rate mortgage might even be offered on a non-recourse basis – there is no personal liability involved. Fixed-rate financing has some disadvantages, however, including:
• Since the lender takes the risk of rising interest rates, and not the borrower, the rate tends to be somewhat higher than in floating-rate situations.
• Many fixed-rate commercial mortgages have pre-payment penalty clauses; the lender, after all, is looking to lock in a rate of return for a fixed number of years.
• To counter the pre-payment penalty problem, you may be able to negotiate a “new buyer assumption” provision. Usually, however, the lender will want to approve of any person or firm that purchases the commercial property from you.
Floating-Rate Commercial Mortgages
In years past, floating-rate commercial mortgages were looked down upon. The notion was “why would a borrower take the risk of rising rates?” The truth of the matter is that someone must take that risk, either the lender or the borrower (or sometimes both). If the borrower is willing to assume some, or all, of that risk, the dividend can be some important savings in interest costs, particularly in the first few years of the mortgage. Floating-rate mortgages are particularly attractive for borrowers who do not intend to hold the property for a long period of time. For a sophisticated borrower, particularly one who has a sense of where long-term rates are moving, the floating-rate commercial mortgage can be quite attractive.
The takeaway here is that floating-rate commercial mortgages are not the “dumb moves” some investors have historically thought and, conversely, fixed-rate mortgages can have disadvantages, depending upon the borrower’s circumstances. Commercial real estate borrowers should make careful assessments of interest rate risk, the stability of the local real estate market, and other factors that are likely to be unique to the borrower’s needs. If a euphemism ever truly fit a lending situation, it does here: When it comes to commercial borrowing related to real estate, one size does not fit everyone.
Commercial Real Estate Lending Calls for Experienced Legal Counsel
The law firm of CKB VENNA has provided both legal and business consultation to commercial mortgage lenders and borrowers for years. We have drafted core loan documentation and have assisted both lenders and borrowers in assessing and managing the risks associated with the commercial real estate. Our firm is also skilled in all forms of litigation. Our attorneys provide preventive training and offer guidance designed to avoid the consequence and cost of litigation. CKB VENNA has offices in Rancho Cucamonga, San Bernardino, and Los Angeles. Contact us by telephone at 909.980.1040 or complete our online form.