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The Small Business Guide to Financing Commercial Real Estate

 

Owning commercial real estate is not for everybody — but it can be a very wise investment for a small business under the right circumstances.

I have a client in Orange County who owns a plastic injection molding company, and I sold him a building for about $1 million in 1995. By last year, the price of that building had increased in value by almost 500%. The building was worth close to $5 million, and the business that occupied the building was only worth a million. If they had continued to rent the building instead of purchasing it 20 years ago, they wouldn’t have built up that $5 million in equity.

Before we discuss the five ways that a small business can finance a commercial real estate purchase, let’s run through the conditions that should be in place before a small business considers that option…

Have you been in business for at least five years? Most entities that loan money to small businesses like to see a profit history going back at least two years. If you’ve been in business for five years, hopefully you’ve been profitable for the last two.

Do you know how big your company is going to be, from a space perspective? The last thing you want to do as a small business is buy a building if you plan to outstrip the facility in a couple years, because then you own an asset that you might not be able to sell if you find yourself in a down real estate market two years down the road.

Is your company privately held? Regardless of how big or small the company is, publicly traded companies typically don’t want depreciation of real estate assets on their books, and as a result, they’re better served by leasing.

Are there tax benefits that the principals of the business can derive? If you’re a C corp with 40 owners, it makes less sense to own the real estate. But if you’re a Mom & Pop LLC, you can benefit from the ownership structure of real estate — in other words, the depreciation on your personal balance sheet.

If you answered yes to all four of those questions, you should consider owning your building as opposed to renting. The question is: How can a small business finance such a major investment? And what’s the best financing method for your small business? Here are the five most common ways that businesses finance commercial real estate, along with their key benefits and drawbacks.

Small Business Association Loans

Also known as SBA loans, real property loans through the SBA come in two types: The 504 loan is a 50% first loan from a bank and a 40% second loan from the government. The 7(a) loan is a 90% government guaranteed bank loan.

The advantages of SBA loans include small down payments (10%), fixed interest rates, the ability to finance building improvements, and wide availability from lending sources. The disadvantages include the origination fees, hefty prepayment penalties, collateral and personal guarantees, and stringent requirements for cash flow, years in business, and profitability.

In other words, there’s quite a bit of paperwork that has to be done. There are also some employment criteria, where you have to increase employment by a certain level, and very strict rules regarding occupancy: You have to occupy a minimum of 51% of the building you’re purchasing. So let’s say you wanted to buy a building but you only planned to occupy 30% of it, and you wanted to lease out the rest to offset your debt service. You wouldn’t be allowed to do that with an SBA loan.

Conventional Financing (Bank Loans)

Once upon a time, if you wanted to buy a building, you showed up at your local bank or savings & loan office and applied to receive a loan of 75-80% of the purchase price. Now, the savings & loans are extinct, there are fewer commercial banks, and those banks would prefer for you to originate an SBA loan because the government is guaranteeing a portion of it and the bank’s risk is lower.

That’s not to say that conventional financing can’t be found anymore. If you have a good relationship with your existing bank and can afford a larger down payment, some banks would love to make a loan for a hard asset like real estate. As a result, they’re less stringent in their underwriting criteria, and there’s also more latitude in terms of being able to pay it off without penalty.

If you have the opportunity to finance a building with only a 10% down payment (as with an SBA loan), that could free up some operating capital that you could invest in equipment, marketing, and employees. But I like the idea of owning a building free and clear, and putting down a larger down payment gets you to total ownership more quickly.

Seller Financing

Seller financing is when a building owner sells the real estate directly to a buyer. If the seller owns a building free and clear, sometimes he can beat the interest rates that a bank or other lender would charge. Back when market interest rates bubbled above 4-5% and a borrower could not seek 90% financing through the SBA, this method was a lot more common.

Aside from the lower interest rate, seller-financed loans are typically a lot more flexible because you’re dealing with an individual as opposed to a lender. Generally, seller-financed deals don’t require an appraisal or an environmental report. (I’d advise a borrower to seek those anyway.) The other thing that a borrower would often avoid is loan origination fees, which can be pretty steep — up to 2.5% of the loan amount. But a seller can originate a loan without charging the borrower those fees.

The reason that you don’t see a lot of seller-financed deals lately is because the interest rate environment has been so borrower-friendly, and they’re competing with SBA loans where a borrower can put 10% down. There aren’t a lot of sellers who are comfortable with only a 10% down payment.

Third-Party Financing

This is where Grandma has a million bucks sitting in a CD earning virtually zero interest, and she’d like to loan the money to you to buy a building for your company. She gets a great return on her money, and the security of the building as collateral. I’ve seen this occur a few times recently, which is probably just a function of the abysmal returns that people get on anything other than hard money loans, where they’re loaning against a hard asset.

These sorts of loans can be made relatively quickly, and like seller financing, they don’t come with the same stringent environmental and appraisal rules that a bank would require. The disadvantage here is, of course, borrowing money from a relative. If things go bad, then you’ve maybe squandered your relative’s nest egg. Sure, they still have the hard real estate asset, so if you are unable to make the debt service payment for some reason, they have the ability to foreclose — not that you would ever want to go through that experience with someone you care about.

I would say that the benefits of third-party financing outweigh the drawbacks, but it has to be the right situation. In other words, if Aunt Barbara and Uncle Frank had a million bucks and you wanted to borrow $900,000 of it, I would advise against it. If they had $10 million and you’re borrowing $900,000, then it’s only 9% of their total nest egg, and it makes a lot more sense.

Purchasing the Building for Cash

The last method is the simplest: A business owner can purchase a building outright for cash. Ideally, you would buy the building (either personally or as an LLC), then lease the building to your company; your company then pays you rent. I’ve only seen this happen a couple of times in my career, but it’s a great arrangement, if you can afford the purchase.

Then again, afford can be a tricky word. I wouldn’t want to tie up 100% of my available cash reserve in a piece of commercial real estate. Now, if we’re talking about 10 or 15% of my available cash, I like it because then you’re able to charge the occupying entity — presumably your company — any rate that you want, and that cash flow goes directly back into your pocket. And if things got tough with the economy, or your business hit a downturn, then you can lower the rent accordingly.

I really like the idea of owning real estate free and clear. Granted, I’m in the minority when it comes to that. Most folks in my industry believe that leveraging commercial real estate is the most important thing, and you shouldn’t own it free and clear. But I’m in the other camp, and I think the benefits of total ownership are too attractive to resist.

Stay tuned for more commercial real estate tips from Allen Buchanan, and connect with him online at LinkedIn, Twitter, and his weekly blog!

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