Purchasing commercial real estate for your small business is complicated. There are many things to know before beginning the process.
The first thing you need to know is there are landmines every where and if one or more of them detonate it can be disastrous for you, your partners, shareholders and employees and ultimately for the future success of your business.
But don’t worry, the information contained in this article will help you successfully navigate the entire process like a pro! So grab a cup of coffee, notepad and pencil and dive in!
Experience On Your Side
What you’re about to read is the culmination of years of experience helping business owners and entrepreneurs like you obtain financing to purchase commercial real estate for their business.
That means when you’re finished reading this article you will be equipped to determine whether to buy your building or continue leasing, how to find the right office space for your needs, how to find the right real estate broker and oh yes, how to successfully obtain the right loan.
Steps To Buying Commercial Real Estate
Let’s pause for a moment with a word of caution
Purchasing commercial real estate for your small business will take considerable time and money so if you’re not willing to commit to both it may better for you to stop the process before you start.
Are you ready? Then let’s begin.
Below are the steps necessary to successfully complete the purchase of commercial real estate for your small business. (Depending on the type of purchase there may be additional steps involved but these steps below cover 90% of purchase transactions.)
- Determine whether to buy or continue leasing your office space?
- Determine the right amount of square footage, the right location, need for room for future growth etc. and begin the search
- Hire a real estate broker to lead the purchase process
- Get pre-qualified by a commercial real estate loan professional
- Submit the right offer and understand contingencies
- Determining the right loan program for you and your business?
- Complete the loan application
- Order a Preliminary Title Report, Appraisal and Environmental Report
- Order an Inspection Report and conduct other due diligence
- Navigate the underwriting process
- Review loan documents for performance measures and accuracy
- Sign loan documents
- Take possession
Believe it or not you have the potential to save thousands of dollars in mishaps simply by reading this article.
So keep going!
Starting, operating and growing a business is no easy task. In fact, most business owners fail to build a sustainable business and quit. For those business owners who succeed, they find themselves faced with a choice to make.
Is It Better To Own Or Lease Your Office Space?
Like many decisions, there are positives and negatives to owning commercial real estate. Let’s explore both sides of the equation and determine if owning your office space is better for you at your stage in the business life cycle.
Advantages And Disadvantages to Leasing
Most businesses if not all start by leasing their office space. The primary reason is it’s easier to lease than to own; it takes less capital and offers more flexibility to accommodate future growth.
Other advantages include more availability, landlord allowances for tenant improvements and in some cases the ability to sub-let to another tenant or assign the lease to another business when prudent.
Disadvantages to leasing include the landlord, who is typically a savvy real estate professional and therefore stronger in contract negotiations, painful annual lease rate increases and personal guarantees that can make it difficult to exit the lease unless favorable exit terms are negotiated prior to occupancy.
Advantages To Owning Real Estate
- Your monthly mortgage payment is likely to be similar to your previous monthly lease payment with the added bonus that you are building equity with each principal payment.
- Your monthly payment is likely to be fixed, especially with an SBA 504 guaranteed loan, which means you will avoid sudden rent increases or exorbitant CAM charges that can be disastrous to a growing business.
- You may be able to sub-let unused any space, subsidizing your monthly payment and increasing your businesses profitability, If negotiated prior to occupancy.
- You may have the ability to reorganize or build out more space, if available, to accommodate growth and the need for new employees.
- Your in total control of the look and feel of your space. This is especially important to enhance company culture and collaboration.
Disadvantages To Owning Real Estate
- Owning your own office space also means saving for a down payment. This can be a substantial amount depending on how much square footage required to operate your business. (On the bright side an SBA 504 loan can help you keep more money in your pocket for working capital and still allow you to buy the building.)
- Similar to owning a home, commercial real estate is illiquid and can be tough to sell in down market. Before obtaining a commercial mortgage do your homework to make sure the space will be adequate for your intermediate needs.
- Be careful agreeing to variable rate mortgages which expose the business to unplanned or increased costs due to rising interest rates. (Unless in a declining rate environment)
- Owning a property means being responsible for routine maintenance and repairs which can take a bite of your profits.
Choose The Right Commercial Real Estate Broker
Now that you’ve decided to purchase commercial real estate for your small business it’s time to choose the commercial real estate broker who will help you identify, acquire and occupy your new office space.
As you can imagine you shouldn’t make this decision lightly so here are a few words of wisdom to help you make the right choice.
- Be cautious of entering into a dual agency which his when the sellers real estate broker also represents the buyer (you)
- Hire an experienced real estate broker
- Hire a real estate broker who specializes in your property type and region
- Ask your real estate broker for references
Get Pre-qualified For A Loan By A Commercial Real Estate Loan Professional
Getting pre-qualified for a loan by a commercial real estate loan professional is important because it determines the loan amount and price range you and your business can afford. This narrows the property search making it easier for you and your real estate broker to identify the right property that meets your needs.
Submit The Right Offer And Understand Contingencies
The right offer is the one that meets your business goals even if the seller rejects your offer.
Ultimately, both you and the seller will have to reach a compromise to strike a deal.
Important! Pay attention because many business owners and real estate brokers fail to grasp the importance of this next step. Include your commercial real estate financing professional in negotiating your loan contingency period.
The loan contingency period is the length of time between the execution of the purchase agreement and expiration of the loan contingency. Once the loan contingency is removed the deposit goes hard and is considered earned by the seller.
Work with your commercial real estate loan professional to negotiate the loan contingency time period to avoid asking for an extension later in the process. Sellers may use the request for an extension as leverage in negotiating other aspects of the purchase.
Determining The Right Loan Program For You And Your Business?
Commercial Loan Options
There are essentially four options to purchasing real estate for your business. A conventional mortgage, SBA mortgage, private money mortgage or seller carry also known as an installment sale.
Depending on your situation all of these have advantages and disadvantages. For instance, conventional mortgages typically have the lowest rates and fees but also require a minimum 20% equity injection and fixed rates up to 10-15 years for prime borrowers. The fixed rate period can be as short as 5 years.
An SBA guaranteed mortgage has the advantage of only requiring a 10% equity injection for mixed-use properties and competitive fixed rates up to 20-25 years. The downside of an SBA loan is the 2.5% – 3.0% guarantee fee. On the bright side, these fees can be financed into the loan which mitigates the out of pocket expense to the borrower.
Private notes and seller carry notes are typically taken in special circumstances where the mortgage either needs to be obtained in a hurry or there is difficulty qualifying for a conventional or SBA loan.
Private money loans are expensive and installment sale or seller carry notes aren’t always the most stable.
Most buyers choose to obtain a mortgage through the SBA 504 program due to the low equity injection requirement, competitive rates and fees ability to be financed into the loan for its duration.
How To Prepare To Own
If you’re set on purchasing real estate for your business start saving for the down payment. Also, manage your year end profit and loss statement and balance sheet and file accurate tax returns which demonstrate your companies true financial status. It may be obvious but you must be able to demonstrate your companies ability to repay the loan. I’ll go more in depth on this topic in another post.
SBA Real Estate Financing
The first thing you need to know is there are two SBA guaranteed loan programs to purchase commercial real estate, the SBA 504 and 7(a).
SBA 504 Guaranteed Loan Program To Purchase Real Estate
The SBA 504 guaranteed loan program to purchase commercial real estate is comprised of two loans. The first loan also referred to as First Trust Deed is provided by an SBA Preferred Lending Partner up to 50% of the purchase price and the second loan refereed as a 2nd Trust Deed by an SBA Community Development Corporation (CDC) up to 40% of the purchase price. The borrower is required to inject 10% equity into the purchase. This is their skin in the game.
Generally, multi-purpose properties may be financed up to 90% loan to value while special purpose properties may be financed up to 85% loan to value.
Loans are fully amortizing, with relatively long prepayment penalty periods up to 10 years, low fixed rates and no covenants on the CDC portion which means that as long as the loan is paid as agreed, there is no concern of the loan being accelerated or called.
Fees are approximately 3% of the guaranteed portion of the CDC loan and may be financed into the CDC’s 2nd Trust Deed.
The 504 program should be used for strong credit clients seeking long term, low fixed rates options who are not planning on moving, growing beyond their square footage or selling their business within the next ten years from purchase.
SBA 7(a) Guaranteed Loan Program To Purchase Real Estate
The SBA 7(a) guaranteed loan program to purchase commercial real estate is comprised of one loan provided by an SBA Preferred Lending Partner which means more flexibility in determining eligibility and qualifying loan applicants.
Similar to the 504, multi-purpose properties may be financed up to 90% loan to value while special purpose properties may be financed up to 85% loan to value.
Loans are fully amortizing, with both fixed or variable rate options, three year prepayment penalty periods and no covenants which means that as long as the loan is paid as agreed there is no concern of the loan being accelerated or called.
Fees are approximately 3% of the guaranteed portion of the loan and may be financed into the First Trust Deed.
The 7(a) program to purchase real estate is primarily suited for clients requiring more flexible underwriting guidelines. This program is also preferred by prime borrowers when a bank is offering low fixed rate options.
Real Estate Property Types
Understanding how the SBA is going to view the type of property your purchasing is important. Multi-purpose properties are able to financed up to 95% LTV while single-purpose properties up to 85%.
The difference between 90% and 85% can be the difference between being able to purchase the property or not.
Multi-purpose properties include the following:
- Light Industrial
- Office Condo
Single-purpose properties include the following:
- Gas Stations
- Car Washes
- Convenience Stores
- Residential Care Facilities
Complete the loan application
Completing the loan application is an important step in the loan process. The application is more than words on a page. It tells the story of your business.
Remember, you know your business better than anyone. Therefore, it is incumbent upon you to clearly and accurately communicate your expert knowledge of your business to the lender’s analyst(s) and decision makers who will examine your businesses financial statements, business practices, the individuals responsible for leading your business and how you’ve handled debt and other obligations in the past.
Order a Preliminary Title Report, Appraisal and Environmental Report
Reports are necessary to completing the loan process simply because banks are not experts at every aspect of commercial real estate. In order to assess risk they need accuate information to make the correct assessment.
The first report to be ordered is typically the Preliminary Title Report which reports the chain of title on a particular property revealing any issues the lender might encounter registering a First Trust Deed of security on the property.
The second report that is ordered is the Appraisal. The appraisal simply defines the value of the subject property on a given day when the report is delivered. Lenders usually will accept an appraisal up to six months old.
Also, though it’s not a guarantee, it is common practice for lenders to transfer an appraisal if for some reason your first lending choice decides not to follow through with the loan.
The appraisal is ordered by the lender in a blind process to ensure the integrity of the report and dissuade lenders and appraisers from colluding to close more deals.
The third report that is ordered is the environmental report. Unlike an appraisal there are various types of environmental reports ranging from less invasive to extremely invasive.
The two most important environmental reports are the Phase 1 and Phase 2. Phase 1 reports identify whether the property is subject to contamination and the Phase 2 report involves conducting testing at the site, mitigating contamination and making a determination of the extent of the contamination and whether further mitigation is necessary.
You will most likely only need a Phase 1 environmental report unless the subject property is a gas station, automotive shop, dry cleaners, car wash or other high risk property type or is located in close proximity to a property that is high risk.
Order an Inspection Report and Conduct Other Due Diligence
The inspection report is ordered by the buyer. There are a couple different ways to go about ordering this report. You can simply order an inspection from a licensed real estate inspector who gets paid to inspect the property, or you can request quotes from experts in their field for example, electricians, plumbers etc. These experts will not charge for their quote but you can then use their quotes as leverage in negotiating terms of the transaction with seller and then hire these experts at the close of the sale.
Navigate the underwriting process
The underwriting process is thought be something the lender undertakes. This is incorrect. The underwriting process is a collaborate process by which a business owner works in tandem with the credit analyst to determine the facts about the businesses financial stability and other factors.
Keep this in mind. The underwriter is processing many files at once and is under constant scrutiny to be quick and accurate. This is a lot of pressure.
Therefore the underwriter will often ask questions to help them better understand the dynamics of your business and enhance their write up or credit memo which is to be presented to their credit committee or credit approver.
The more responsive you are as the applicant to the underwriters questions the more quickly and accurately the file will move from underwriting to a favorable decision.
We only work with lenders who are highly skilled at pre-flighting your loan request to avoid spending weeks or months in underwriting to be declined.
Review loan documents for performance measures and accuracy
Loan documents should never be seen for the first time at the signing table. If this happens to you put on the brakes and request the lender send you the loan documents via a secure link.
You should have the opportunity to review the loan documents without the pressure of signing and have the opportunity to have the loan documents be reviewed by your attorney if you so wish.
Here are few items to be aware of in the loan documents.
- Prepayment Penalty – The prepayment penalty outlines how much of the loan may be paid in advance before the maturity date without incurring a monetary penalty. Though a Letter of Interest or Term Sheet should outline this at the beginning of the process, sometimes this is not the case. Also, if not offered, you should negotiate a 20% annual prepayment allowance.
- Covenants – Covenants are performance measures the bank will use to grade and rate your performance based on a predetermined schedule which is usually quarterly, bi-annually or annually. Failing to meet one or more performance covenants in the future can be devastating for your business. Make sure to discuss these with your lender before signing the loan documents.
Sign loan documents
Signing the loan documents should be stress free based on the fact you’ve already reviewed them and negotiated them to your liking. However, just to be sure, you should review the salient points one last time including, rate, term, prepayment penalty and covenants to ensure nothing has changed.
The Trust Deed will record up to three days after loan signing at which time you will be given the keys and take possession. Hopefully you’ve done everything you can to make sure you are taking possession of the property you agreed to purchase.