As the name would suggest, commercial real estate loans are loans designed to finance the purchase, development, or renovation of commercial properties. As such, they’re typically secured by the property being financed, which serves as collateral for the loan. The property can range in nature from office buildings and retail spaces to warehouses and industrial facilities.
However, not everything is as straightforward as it seems.
While this kind of loan can provide significant benefits to your business, there are situations wherein the opposite is true. They can have negative implications and potentially put your business under financial strain. Here’s how:
- Debt Burden and Cash Flow Challenges
- Property Value Decline and Occupancy Issues
- Interest Rate Risks and Limited Flexibility
Let’s look at these a little closer and talk about how you can mitigate the risks.
The Capital Involved in Commercial Real Estate Loans
Even after taking every precaution, securing a loan still adds to the overall debt burden of your business.
Debt burden refers to the total debt your business carries and the impact it has on operations. It’s measured as a ratio between financial health and the ability to meet financial obligations. If your business already struggles with existing debt or has a limited cash flow, the additional loan repayment obligations might be too great. They can strain financial resources and make it difficult to meet other financial obligations or operational expenses.
On that topic, you can’t control cash flow.
As with any loan, commercial real estate loans typically come with regular monthly payments. These include principal and interest. If your business cannot generate sufficient cash flow to cover these payments, your chances increase of defaulting on the loan. Cash flow problems are more common than you might think. We know it’s an old one, but CPA Practice Advisor put out a great article on the matter.
It’s an easy read when you get the chance. In it, they explain the issue isn’t that business owners don’t have enough cash in the pipeline—It’s that the funds aren’t readily available for real-time expenses.
What you can do
It’s possible to mitigate the risks of debt burden and cash flow challenges associated with securing a loan. However, it’s not easy.
By following these strategies, you can strengthen your business’s financial position:
- Conduct a thorough financial analysis and evaluate your debt repayment capacity.
- Request a realistic loan amount that aligns with your business’s financial capabilities.
- Maintain adequate cash reserves to handle unexpected expenses or disruptions.
- Avoid balloon payment and choose fixed-rate terms that suit your business’s cash flow.
- Diversify your debt and assets to minimize concentration risk.
- Perform stress tests to assess your business’s resilience to adverse scenarios.
- Analyze your business’s industry, market conditions, and potential risks.
Commercial Real Estate Loans Don’t Change
But your business does. And often, it’s outside of your control.
The value of commercial properties can fluctuate. This is due to a variety of factors. Things like changes in the real estate market, economic conditions, and specific factors affecting the property’s location or industry all have an effect. If your property’s value declines significantly, it can result in negative equity. This means the outstanding loan balance exceeds your property’s value. This then means greater challenges if you need to sell the property or refinance the loan in the future.
As unpredictable as property value is, people are even more so.
If your business relies on rental income from leasing out a portion of the property to generate revenue, difficulties in finding tenants or maintaining high occupancy rates can impact cash flow. If rental income falls short, it can make it harder for you to meet loan payments.
What you can do
When applying for a commercial real estate loan, you can also take steps to mitigate the risks associated with property value decline and occupancy issues.
It’s possible to reduce the potential impact on loan repayment ability and improve overall loan performance if you:
- Conduct research to assess your property’s potential appreciation and demand.
- Choose a property with a strong location, favorable market conditions, and potential for growth.
- Diversify your business’s property portfolio to spread the risk across different locations.
- Develop a business plan that attracts and retains tenants.
- Maintain proactive tenant management, maintenance, and amenities.
- Implement marketing and leasing strategies that minimize the time between occupancy periods.
- Offer lease agreements with longer terms that provide stability for tenants.
- Monitor local real estate to stay informed about economic trends and factors.
And Sometimes Commercial Real Estate Loans do Change
Even if your business doesn’t.
Commercial real estate loans can have variable interest rates. These are subject to market fluctuations. If interest rates rise significantly, it can lead to higher loan payments and increased costs for your business. This can be particularly challenging if you’re operating with slim profit margins or have limited flexibility in adjusting prices or rental rates.
And that’s just the beginning.
Owning a commercial property through a loan can limit your business’s flexibility to adapt to changing circumstances. What happens if your property becomes less suitable for your business’s evolving needs or market conditions? Especially when the loan obligations prevent you from relocating or making necessary modifications?
What you can do
As always, you can mitigate the risks of interest rate fluctuations and limited flexibility.
By implementing these strategies, you better manage your commercial real estate loan and adapt to changing market conditions.
- Choose a loan with a fixed interest rate or explore hedging strategies.
- Consider a loan with an interest rate lock-in period.
- Assess cash flow under different interest rate scenarios.
- Negotiate flexible loan terms for prepayment or refinancing options.
- Seek advice from financial professionals on managing interest rate risks.
- Maintain financial reserves for cushioning against rate increases.
- Avoid excessive leverage for enhanced financial flexibility.
- Regularly review the loan agreement and explore opportunities for renegotiation or refinancing.
A Friend in the Business
Of course, the best thing you can do for your business is work with people who care as much as you do.
At Blau & Berg, that’s exactly what we do. We care.
Now, we don’t necessarily offer loans or financial services. However, our family has been in the commercial real estate industry for almost a thousand years. Maybe a loan isn’t the right thing for your business. We can help you find what is.
