Why commercial mortgage balloon loans remain popular
Balloon loans explained
- Common feature in commercial loans
- Large balances remain at the end of loan terms
- Balances must be paid off or refinanced at the end of loan term
- Balloon loans can make sense but carry risks
So-called balloon mortgages are rare today in the home-loan market. In commercial real estate financing, though, they remain a standard feature.
A balloon loan gets its name from the payment structure, which differs from the type of mortgage that most homeowners take out.
In the standard home loan, you pay off the loan’s interest and principal over the term of the loan, typically, 15 or 30 years of regular monthly payments. Homeowners are considered lower risk because their loan is backed by a government-sponsored enterprise, such as Fannie Mae or Freddie Mac.
Commercial balloon loans are considered higher risk. Government-sponsored enterprises do not back most commercial real estate loans; there’s no Fannie Mae for the majority of commercial real estate loans. Commercial borrowers – generally business owners or entities – still make fixed monthly payments, but the loan isn’t structured to end with a zero balance. With commercial balloon loans, the term of the loan ends after three, five or seven years, at which time the entire remaining balance of the loan becomes due, what is known as a “balloon payment.” When the loan term ends, the borrower is left with a big balance that needs to be paid at once. Normally, what that means is that the borrower has to refinance a big debt.
You may think that this is a terrible way to structure a loan. In the world of commercial real estate, it often is the best structure both for borrowers and lenders.
Advantages of balloon loans
Lenders offering commercial real estate loans hesitate to lock in terms for 15 or 30 years, as they do with a residential mortgage. When the balloon payment is due, commercial borrowers often seek to refinance, which allows lenders to evaluate a commercial property every few years. Commercial property values can change quickly in individual markets and locations. Properties can fall into disrepair or a building can open up across the street that makes other buildings in the area obsolete.
Balloon loans are attractive for commercial real estate owners. Lenders typically offer more favorable rates and lower loan-to-value terms. In some cases, the borrower pays just the interest charges or a small percentage of the principal amount, keeping the payments low. Commercial properties are valuable to the owners for their ability to produce a fixed income above what the owners have to pay to service debt and maintain the property. It doesn’t matter if they carry a debt, so long as they meet their income goals. So, many owners expect to repeatedly refinance the property debt each time the loans come due.
Risks of balloon loans
Balloon payment loans do carry risks. These loans present no problems in good times, when asset values are rising, but when commercial property values fall, owners can have problems refinancing their loans when the balloon payment is due. Most commercial owners don’t have ready cash to cover a large balloon payment.
As lenders pull back their lending streams or ramp up their restrictions, property owners can get caught in a bind. For example, between 2006 and 2007 (the last big boom), many commercial property owners took out loans that were structured as 10-year commercial balloon loans. These loans were packaged into securities. When borrowers went to refinance, many found that their original assets had been overvalued due to looser lending standards or the properties had struggled to produce expected incomes.
Even in good times, some commercial properties underperform and get devalued by lenders. When property values fall, lenders often refuse to refinance the entire balloon payment.
The property owner will often have to load in their own money to cover a shortfall. In extreme cases where no financing is available, the owner may have to quickly sell the property. Borrowers also usually have limited options on when they can refinance a commercial loan, as most commercial loans carry stiff penalties for refinancing early. All this makes it challenging to time the market to avoid future problems. In most cases, however, strong preforming properties are able to get refinanced when the balloon payment comes due.