Whether you’re buying commercial real estate as part of your investment strategy, want to stop leasing and put down roots, are about to lease, move in or renovate a space – or simply want to refinance the debt on a property you already own – chances are, you’ll be looking to banks or other lenders for financing in the form of a commercial real estate loan.
What to Know Before You Apply
Financing is key to running a successful company, as it allows you to manage cash flow and invest in capital expenditures such as equipment and renovations that can help your business realize its full profit potential.
Before we delve into the different financing options for commercial real estate, it’s important to understand what factors lenders look at when deciding whether or not to approve a commercial real estate loan.
While you determine which types of financing you need, your management team and accountant can work on making sure your business scores as high as possible on the following factors, so you get the best rates and repayment terms from your lender:
Your cash flow and readiness in case of a crisis
To verify that your company is financially stable and able to weather a storm like a sudden economic downturn, your bank will review your financial statements for the last few years, look at your current books and ask to see revenue projections for several years ahead. They’ll then compare your earnings and cash flow to averages for similar-sized businesses in your industry or sector. They’ll also check that you’ve set up a contingency fund for business emergencies.
Your debt ratio and your ability to manage debt
Being debt-averse can be almost as bad as being overextended. If you’ve never managed debt, a bank may hesitate to be your first kick at the can.
In addition to your cash position, your bank will be looking for collateral that can serve as security for the loan and liquidate quickly in the event of a default.
One of the things successful business owners do better than unsuccessful ones is understand the limits of their competencies. Your lender will want to understand what sort of experience key management staff have and who’s advising you in addition to accounting and legal professionals.
Your business and personal credit scores
Your business credit score includes your payment history, delinquencies, length and history of accounts with various vendors and suppliers, and a list of the types of business credits you currently have and use regularly.
Lenders use the number and information to determine your ability to repay a business loan or make on-time payments, and the higher your score, the better. However, if your business is new, you won’t have much history, so your personal tax statements and credit score will be used instead. A poor credit score may make it more difficult to obtain financing.
Your industry’s or sector’s health
If a bank thinks your industry or sector is on shaky ground, they may not want to loan your business money – or if they do – they may set higher interest rates and more stringent repayment terms. If you don’t agree with their assessment, you’ll need to present credible commercial real estate market trend research that says otherwise and help them understand how you intend to succeed where others have failed.
Your willingness to share the financial load
Entrepreneurs who invest their own money in their company demonstrate a willingness to share risk. If, on the other hand, a business runs exclusively on loans, lenders may perceive the owners as less committed to its long-term success.
Financing Options for Commercial Real Estate
The top financing options for commercial real estate in Canada include:
Commercial Mortgage Loans
Mortgage loans are the most popular financing option for commercial building purchases and operate much the same as a home mortgage. While the interest rate is important, the loan-to-value ratio (LTV) – or the percentage of the property’s value that the bank will finance – is crucial.
Banks may finance from 75% to 100% of the value of commercial real estate, depending on the building’s condition, resaleability and other factors. However, lenders generally consider LTV ratios exceeding 75% risky, particularly for properties that are less than 50% owner-occupied. Any gap between the cost of a building and its financing will need to be covered by your company’s working capital or your own personal funds.
The next thing to consider is the amortization period. The longer the period, the better, as it’ll allow your company to retain more money in the short term. The amortization period of commercial real estate mortgage loans usually ranges from five to 30 years.
Lastly, by asking them what repayment options they’ll offer, you’ll get the best understanding of how flexible your lender will be. For example, will they allow you to delay payments for a year or two to help your business ramp up after your move? Will they include a portion of the cost of a renovation or retrofit into the mortgage loan, so you won’t need to burn capital or seek different financing for those projects? Will they accept temporary deferments or forbearances or allow interest-only repayment in the event of an economic crisis? All can involve temporarily postponing, pausing or lowering your loan payments while the economy and your business recover.
Leasehold Improvement Loans
Businesses seldom move into leased commercial real estate without renovating to increase the ease and efficiency of their operations, let alone configure equipment and machinery. Leasehold improvements are the term for these changes. Leasehold improvements and building improvements are not the same. While a building improvement benefits everyone, a leasehold improvement benefits an individual tenant only.
You can use a leasehold improvement loan to pay for upgrades or large-scale renovations to a leased space. Depending on the value of the improvement, a bank may accept the improvement as collateral for the loan, which could result in a lower interest rate than if the loan was left unsecured. A leasehold loan is usually amortized over three to five years, and lenders may allow you to negotiate a principal holiday for the first half or full year of the loan.
Working Capital Loans
Working capital loans are short-term loans which are delivered in a single payment and usually amortized over three to five years. They come in handy after you purchase commercial real estate or sign a new lease and help you fund your business’s day-to-day operations. They can be used for practically anything that requires extra cash flow, such as the creation of marketing and sales materials, website or app development, payroll, etc.
Working capital loans are generally unsecured, and lenders often allow you to negotiate a principal holiday for the first half or full year of the loan.
Equipment loans are a smart way to purchase computers or other equipment for your business. Since lenders consider the equipment itself as collateral for the loan, you don’t need to secure it with other assets. The amortization period extends through the lifespan of the equipment or is set to between five and 12 years.
A demand loan has no fixed maturity date and can be paid back in full or in part at any time without the penalty for early payment that you might experience on other loans. You can renegotiate the loan up or down as your business situation changes, making them an extremely flexible option at first glance – however – the fact that the lender can require repayment of the loan at any time adds risk.
Business Lines of Credit
A business line of credit is similar to a personal line of credit. Once your bank and you settle on the amount of the credit, you can utilize as little or as much as you want, day in, day out, up to the loan’s limit. You pay interest only on the amount of money borrowed at any one time. So, for example, if your line of credit is $25,000 and you borrow $5,000 to buy equipment that suddenly goes on sale at your local retail supply store, you pay interest only on the $5,000 portion. You can then pay off the $5,000 bit by bit or all at once. When it’s paid off, you have access to the full $25,000 credit again.
Vendor Loans and Financing
In a vendor loan, the seller of a commercial real estate property gives the buyer a loan to cover a portion of the purchase price so the transaction can proceed. Because the seller acts as the buyer’s bank, the buyer benefits from immediate ownership of the property.
Vendor funding can take the following forms:
- Vendor Take Back Mortgage (VTB)
- Agreement for Sale (AFS)
Know Your Financing Options Before You Invest in Commercial Real Estate
One size does NOT fit all when it comes to financing commercial real estate purchases, leases or leasehold improvements. Which financing options you choose – and yes, you can pick more than one – will depend on how much red or black your company’s balance sheet shows and how well the lender’s rate and terms mesh with your business goals.
Explore all your options before deciding, and shop around to compare rates and terms. Your accountant will be able to advise you on the maximum amount of money you should borrow at any one time, as well as which loans will be the easiest to repay.
Before you sign any commercial real estate loan agreement, be sure you understand both its terms and the financial implications for your business – now and in the future. Have your lawyer and accountant thoroughly review it and wait for their thumbs up to sign.