Refinancing Commercial Loan - best options?

Question

Before I decided to educate myself on REI, I jumped into an offer on a commercial condo to open a retail shop. Based on that, we got a conventional commercial loan with the terms of:

1. Can only use the loan proceeds to open the shop, no other purposes

2. 5 year pre-payment penalty

3. 10 year balloon, 20% down

Since then, we’ve decided our best move with this property is to renovate it into a residential condo and either rent it or flip it. Well, we are closing in a week so it’s too late to change the type of loan without losing the deal. My thought is to close with the commercial loan then refinance to something more like a rehab or investment loan.
I originally thought I could just keep the commercial loan and renovate into a rental. But I am ignorant enough to not know whether I will “get in trouble” for changing the use. I have been told that with the commercial loan through the credit union, I have to provide financials annually.
I would love to get some insight from those of you who are deeply involved in this area. The numbers on the property are:

Cost: $250k, Reno $45k, ARV: $400k

Thank you!

Sasha Mohammed · Answer

i think more importantly is to see what the terms are on acceleration clauses.

The reason the purpose of the loans are so important are to protect the lenders from violating different laws. I'll give you a super simplified example: if you buy a property and say you're NOT living in there, and then you do move into it; now the lender could be in violation of a litany of laws, including consumer protection laws, just based on what disclosures they did or didn't send out to you during the loan process, the rate, the fees, the terms, etc. Now they get in trouble because you told them one thing but did another. Not saying that's the case here, but there's a reason they are so particular about the use of funds.

sounds like a step-down prepay, which is typical. But see if you can get an idea of reasons why the lender could call the note due (AKA "acceleration clause). If they find out you've changed your mind and started converting to residential, are they going to stick their hand out and immediately demand the entire balance from you?

Added: it will cost you a lot more to refi out of this once you close on it. It might be smarter to stop this loan and start a new loan for what you intend to do. I'd hate to see you throw good money after bad, with a 5% prepay in year 1, that's likely what would be happening, and that's not even taking into consideration the origination fees and transactional costs (title/escrow) you'd be paying AGAIN on the new transaction.

Devin Peterson · Answer

Amber,

Make sure you check out the terms of the deal on the prepayment penalty that's a biggie. Second, a little more info on the property would be helpful. Is this a retail shop mixed use or what? I can help you locate some good local mass lenders if you can sow together a successful exit strategy without penalty. send me a pm

Amber Cerone · Answer

Thank you so much! The explanation of why it's not just simple to change the use after getting a specific loan is very helpful. And I would've definitely stopped this one and changed once I was more educated, but we close in two weeks and if I stop now I'll lose the property because the sellers are not patient and it was a good deal. I'm thinking I'll go with the shop for now (after all, it was my original plan) and I'm going into it knowing that in a few years I can convert, have less of a prepayment penalty and either rent or sell, both with pros & potential to make money.

Doug Smith · Answer

5% of $300K is $15K...so the most you'll pay as a prepayment penalty is that. I think you have options. Your Principal and Interest Payments will be about $2200/mo. You'll want to calculate in taxes, insurance, and other costs to see what your rental break even is. Do you know how much you can rent it for? If you do rent it, will you be cash-flow positive? The issue is that the loan is being underwritten as an owner-occupied property. Renting it might give the bank heartburn vs opening a shop. They likely will take issue with that and might call the loan. Do you still plan on doing the retail shop? If not, I would certainly have a chat with the bank to get their take on it. A local bank is going to want you to set up your operating business accounts for the shop with them and they will monitor it closely. You won't just be able to sneak it by them in this instance if you choose to rent it. How much time before you have to close? If it's more than 3 or 4 weeks, you might have time to do more options.

Amber Cerone · Answer

Partnof my question is if it makes sense to renovate and hold or renovate and sell. I feel it’s a good investment either way, just not sure if one of them is better financially for future REI.

Doug Smith · Answer

If it's a normal commercial loan, you're likely looking at a prepayment penalty of 6 months worth of interest. How much earnest money do you have "hard" (non-refundable). Are you going to hold it for 5 years? Can you still buy-down the prepayment to say three years? What are the loan terms (rate, etc)? How does the prepay work? Is it a 5/4/3/2/1 or a some other type of prepay? In order to truly answer your question, I think I need to know more. You are correct about a credit union or bank doing an annual review. They will be sticklers for the loan covenants...much more so than Fannie Mae or Freddie Mac would be for a residential loan. I was a commercial banker for a long time and did a lot of loans like this. I'm not thinking your necessarily in a bad position with this loan, but I would need to know more to give you the advice that you seek.

Amber Cerone · Answer

Thanks, Devin! The condo is currently being used as a retail space but is also zoned to be a residential condo.

The prepayment terms are Year One 5%, Year Two 4%, etc.

Refinancing Commercial Loan - best options?

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