What to expect in financing your first commercial real estate purchase
Congratulations! While it may seem like only yesterday, the business you started just a few short years ago on a dime and a prayer has begun to prosper. You’ve come to realize, however, that along with the successes comes a new set of challenges. In order to maintain your level of growth, you need to increase inventory and equipment, and add employees; but your ability to do so is restrained by the four walls of your leased space. Fortunately, your lease is approaching maturity, so the time has come to search for new space, and you’ve decided that buying rather than leasing may be the better option. But where do you start?
You might expect a real estate broker’s response to that question to be “…with a call to a broker,” and there’s certainly a basis for some preliminary fact-finding as you spot available properties that might suit your purposes, but the first call in earnest should be to your banker. A commercial lender’s familiarity with you and your business is an important foundational component of the working relationship you’ll develop over time, and if you haven’t already had an occasion to begin such a relationship, the obvious choice might be to start with the bank where you maintain your business accounts, where the lender can begin by viewing your recurring deposits, disbursements, average balances, and the manner in which accounts are managed. But to be sure, that’s just a start.
Ask if they are an approved Small Business Administration (SBA) lender, and ideally a Preferred lender. Most local banks are, but if not, you might seek one out that is to ensure that you are able to weigh all options available to you. The two most common forms of real estate financing are traditional, where loans are structured according to the bank’s own lending policies and practices; or SBA, where loans are structured within SBA-established standards (perhaps with overlays imposed by the lending bank).
With traditional financing, the lender is entirely reliant on primarily you and your business as the borrower, and secondarily on the real estate securing the loan for repayment. SBA loans are also extended based on these fundamentals, but are also partially guaranteed by the federal government, and with this further level of repayment assurance, the bank is able to offer more flexible terms than with conventional financing, perhaps the most significant of which is the down payment requirement. While you might find variances based on the level of credit and collateral risk, and each bank’s own lending policies, traditional financing commonly requires a 30% owner-contribution while SBA will likely require only about 10%.
Further nuances that may be important to you are the loan’s terms, the credit standards and debt coverage ratios (net operating income / current year’s debt service) required to qualify, the costs associated with the loan, or its structure. A traditional loan will likely require an owner’s credit score of 700 or above and a debt coverage ratio in excess of 1.25, while an SBA loan might allow slightly lower standards of 680 and 1.15 respectively. Both will involve much of the same lender and third party fees, but an SBA borrower will additionally incur a potentially significant guarantee fee. Traditional loans are often structured on a 20-year amortization schedule with a shorter term balloon or on a variable rate basis. SBA real estate loans may also be variable but are fully amortized, typically over 25 years. Traditional financing may offer a slightly lower interest to exceptionally qualified borrowers in comparison to an SBA borrower, but the SBA establishes caps on the rates lenders may charge, so rates may be preferential for an SBA borrower with higher risk factors.
Regardless of which option you deem most suitable for you, be prepared to divulge a host of detailed information about both yourself and your company, and to enlist the assistance of an accountant. Lenders requirements may include business and personal financial statements, profit and loss statements, the past 2-3 years of tax returns, a business plan, your financial and cash flow projections, and management resumes. They may also require as may be applicable to your scenario, rent rolls on the non-occupied portion of the building you’re purchasing (may not exceed 49% with SBA), or statements on other significant business interests you may have. Additionally, an SBA loan will require SBA-specific paperwork, such as the SBA loan application.
Through this process, the lender will be able to offer guidance and set specific expectations such as the amount that you may inevitably qualify for and your cash requirements to obtain such a loan, along with other criteria that may be relevant to your situation. Armed with this detail, now it’s time to call your trusted real estate advisor to begin your search for the right property at the right value that will enable you to achieve your near and longer term goals.