Does the thought of paying rent to your s commercial landlord for eternity make you cringe?
Do you get a little bit of FOMO when you hear stories about other people building empires with real estate?
The decision to purchase your own space from which to operate your business is a major one. MAJOR.
And one of the biggest complexities of that decision has to do with the vagaries of commercial real estate mortgages.
Before we get into that, we do have a very time-sensitive notice for restaurant owners:
THIS WEEK, the SBA opened applications for the Restaurant Revitalization Fund (RRF). This new program provides relief funds for restaurants, bars, and other food and drink establishments that have lost revenue due to the pandemic. To read the SBA program guide, go here.
Please share this helpful info with any restaurant owners you may know, to make them aware of this program. It is expected that the funds allocated to this program will go quickly, so we want to make sure that all restaurant and bar owners are aware of it.
Now, let’s explore how to make your dream of owning your office, store, or shop a reality.
What Business Owners Need to Know About Commercial Real Estate Mortgages
“You just can’t beat the person who won’t give up.” – Babe Ruth
For many people, the American dream includes a cozy home with a manicured lawn, and our home loan system is merrily set up to make this dream a reality for quite a few people.
But for entrepreneurs dreaming of owning their own store, shop, or office location, the dream is a lot murkier. There are quite a few differences between residential mortgages and commercial real estate mortgages, and you need to be sure you fully understand what you’re getting into before taking the plunge into commercial property financing.
Primary Differences from Residential Loans
The United States has some of the best home loan options in the world. The most common loan type, which you’re probably familiar with, is a 30-year, fixed-rate loan. These residential loans are readily available, have low interest rates, fairly low fees, and carry no prepayment penalties.
Commercial real estate mortgages tend to be the polar opposite.
Commercial mortgages tend to be much shorter time periods. Five to ten years is a typical loan term. The monthly payment is often calculated based on a 20 or 30 year time period, but the loan itself comes due much sooner. At that time, a balloon payment is required, which means that you must either have the cash to pay off the loan, or you must refinance it. Most business owners end up refinancing into a new loan.
But you don’t want to refinance too soon. No, no. Unlike residential mortgages, commercial loans almost always have a prepayment penalty for refinancing too early. For example, a five year loan will typically have a two or three year prepayment penalty. It’s pretty common for a 10-year loan to have a 5-year prepayment penalty.
These penalties are pretty stiff, also. A common structure is to have a gradually decreasing percentage of the loan balance as the penalty. For example, a loan with a 5-year prepayment penalty period might charge 5% of the loan balance if you pay it off in the first year, 4% in the second year, 3% in the third year, 2% in the fourth year, and 1% in the fifth year. This is referred to as a step-down prepayment penalty. There are also other methods for assessing this penalty that get pretty complicated.
You may be able to avoid prepayment penalties by agreeing to other terms that benefit the bank, such as a floating rate loan. As the name suggests, this is a loan with a variable interest rate. Your mortgage contract may stipulate a min and max interest rate, and the time period in between adjustments. In a low interest rate business environment like we have right now, it can be a difficult decision to choose between fixed and floating rate loans.
You’ll also find that interest rates on commercial mortgages will usually be higher than on residential loans. This is because of the government-backed entities, such as Fannie Mae and Freddie Mac, that buy up residential loans. Since this doesn’t exist in the commercial mortgage world, banks must manage their lending risk themselves, and thus they tend to charge higher rates for that risk.
Commercial properties are going to require significantly greater down payments than residential loans. While no money down, 3.5% down, and 5% down loan programs are quite common for homes, commercial loans will almost always require a minimum of 20% to 30% down.
Lastly, the fees that you’ll pay in obtaining a commercial mortgage might make you shed a few tears. Residential mortgages tend to have total fees in the range of 1% to 2% of the loan amount, whereas commercial mortgages frequently have fees in the range of 3% to 5% of the loan amount.
Still craving your own office building? Let’s talk about qualifying for this loan…
Commercial Mortgage Qualification
As crazy as this may sound, it’s absolutely possible for a person to buy a home with no money down, a 580 credit score, a bankruptcy filing on their record, and even while owing back taxes to the IRS. Such loan programs not only exist but are also promoted and backed by federal agencies.
Qualifying for a commercial real estate loan is another beast altogether.
Qualification for commercial real estate mortgages is primarily based on the ability of the property to support itself. In other words, banks want to see that the property can generate enough rent to cover the mortgage payment, taxes, insurance, and other expenses, plus have a little extra left over every month. This is far more important than your own personal credit score or personal income. A lender will want to evaluate existing leases on the property if there are multiple tenants, look at the history of tenant stability, and conduct other evaluations on the property itself.
If you are purchasing a property that won’t have other tenants other than your own business, then the lender will get quite nosey about the financial health of your business. In short, they’re going to treat your business as a “tenant” and evaluate the ability of the property to support itself based on phantom “rent” your business can pay.
On top of that, the bank may want to see significant cash reserves in your business. If your business is struggling to make ends meet every month, and carries very little cash, it’s going to be very difficult to purchase a property. There are some exceptions to this for SBA loans, however.
If the property you’re looking at in has other businesses leasing space in it, the lender may question your ability to manage the property and those tenants. Some lenders will impose a minimum experience requirement for property management, or demand that you retain the services of a commercial property management company as a condition of the loan. If your business is going to occupy at least 51% of the square footage of the commercial property, then this is another area where an SBA loan can be attractive.
Despite the costs involved in obtaining commercial real estate mortgages, and the strict qualification requirements, it can absolutely be worthwhile. In addition to the possibility that owning will be cheaper than leasing your space, you will benefit from any appreciation in the property’s value.
On top of that, there are significant tax benefits to owning commercial property, just like there is for owning your home. All that interest you pay is tax deductible by your business, as are property management fees, maintenance costs, insurance, and property taxes. Owning the property also provides some amazing estate planning options if you plan to pass your business along to your heirs.
Buying your own commercial property is a huge step for your business. We’d be happy to review the financial pieces of such a transaction with you, including the potential tax planning opportunities this will present. Schedule a time here: