Pros and Cons of Balloon Payments in Commercial Real Estate Investing

Savvy commercial real estate investors know that one of the best ways to increase profits is to minimize monthly carrying costs and pay as little as possible for any borrowed money. Loans with balloon payments are a strategy that can increase profits and reduce monthly expenses on an investment property. But this type of financing isn't for every investor (or every property). Here are the pros and cons of balloon payments in commercial investing.

What is a Balloon Payment?

A balloon payment is a large, lump-sum payment tendered at the end of a loan. Unlike standard mortgages, which include interest, principal, taxes, and other expenses, the monthly payment on a loan with a balloon payment is typically smaller, often including only interest. 

For example, an investor takes a loan on an apartment rental property. The amortization schedule is set so that the first five years of loan payments (paid monthly or quarterly) only include the interest. The remaining loan amount will be due in one lump sum when the five years are up. At this point, some investors refinance at a more favorable rate, and some may sell the property to repay the loan.

Pros of Balloon Payments

Balloon payments are a tool many experienced investors harness to build their portfolios and increase their ROI. Here are five reasons why these loans work.

1. Initial Monthly Payments are Lower

Lower monthly payments are attractive to investors with little working capital. They are also suitable for commercial real estate investors looking to minimize all costs associated with borrowed money so they can focus their cash on renovating or repurposing an investment they plan to sell.

2. Financing is Flexible

Short-term interest rates for loans with balloon payments are often lower than their longer-term counterparts. This is a significant pro for more expensive properties, as a lower interest rate can save investors thousands of dollars.

3. Well-Qualified Borrowers are Approved Quickly

While some borrowers may not qualify for a balloon payment due to the high risk of default, those with excellent credit and a proven history of financial success can easily secure this type of loan. Financial institutions appreciate the short term of this loan, as it decreases their risk, especially when the borrower is exceptionally creditworthy.

4. Loans with Balloon Payments can be Refinanced or Sold

If an investor needs to free up cash to renovate or buy into a less affordable area, a balloon loan is an excellent solution to lowering their monthly costs. One of the significant pros is that a loan can be refinanced (or a property sold) at any time before the balloon payment is due.

For example, consider a new development project where a property is built for mixed-use occupancy over two years, with full tenant occupancy planned for year three. A balloon payment decreases costs during the development phase, and the investor can sell the property after occupancy (or refinance the loan) before the balloon payment is due. If the property appreciates as it is developed, this is pure profit after a sale.

5. Investors Save on Interest

If an investor plans to sell a property before the balloon payment is due, they could see considerable savings in interest. Because buyers who qualify for this generally have excellent credit and the loan is short-term, interest rates can be much lower. 

Cons of Balloon Payments

Balloon payments are not for every property, and they aren't for every investor. Here are five cons of this type of commercial investment financing.

1. The Risk of Default is Higher

The balloon payment can be hundreds of times higher than the monthly payment, and the loan may come due sooner than the investor thinks. This substantial payment at the end of the loan may cause investors to default if they cannot refinance or sell the property in time.

2. Interest Rates Are Not Guaranteed

Many investors rely on selling a property with a balloon payment, but rising interest rates may hinder that effort. Some investors find themselves in a tight spot when higher interest rates scare buyers away or refinancing costs skyrocket.

3. Market Risks Become More Relevant

The economy influences every aspect of real estate, from residential to commercial. If the market suffers a downturn or significant slowdown, investors might find themselves with a property that has decreased in value. This decrease can make selling the property or securing a new loan more challenging.

4. Little to No Equity Generation

If an investor plans to buy a commercial property and keep it to build equity, balloon payment loans aren't necessarily a good fit. Equity is generally built as a loan's principal is paid, but when the monthly payment only includes interest, there is no equity generation. This is not necessarily a deal breaker but something to remember.

5. Pressure Builds as the Loan's End Nears

It's easy to put the balloon payment on the back burner when sitting at the closing table, but the pressure starts to build as the end of the loan's term nears. If investors don't have a plan, the pressure can be overwhelming, especially if income from the property isn't enough to cover the balloon payment and selling or refinancing isn't possible.

When Balloon Payments Make Sense

If you are an investor with excellent credit, considering a balloon payment is great for the following scenarios:

• Investments are short-term: You plan to hold the property briefly and sell before the balloon payment is due.
• The market is rising: Strong markets mean increased property values and a better chance of refinancing or selling.
• Property has substantial cash flow: Properties already generating significant income reduce the stress of a balloon payment.

When Balloon Payments are Too Risky

With or without good credit, there are times when a balloon payment doesn't make sense:

• The market is uncertain (or falling): This could jeopardize property values, interest rates, and the potential for refinancing or selling.
• You want to hold the property: A full amortized loan builds equity and is a better long-term commercial real estate investment option.
• Interest rates are higher for longer: Higher interest rates make refinancing more challenging (and more expensive).

Are Balloon Payments in Commercial Real Estate Right For You?

The best way to decide if balloon payments are right for you is to consider your risk tolerance, look at your investment goals, and evaluate your available cash. Every investor is different, so take the time to consider the pros and cons of balloon payments in commercial real estate investing before making a decision. 

When you're ready to find make your next investment, don't act without proper due diligence. Explore how Crexi Intelligence leverages advanced analytical tools to deliver actionable market insights, optimize property evaluations, and streamline your investment strategy. 

Ben Mizes is the Co-Founder and CEO at Clever Real Estate, the nation’s leading real estate education platform for home buyers, sellers, and investors.