Guide to Commercial Mortgages
A mortgage is probably one of the best understood financial products. After all, many of us have mortgages to buy our homes. So it is with commercial mortgages, which are taken out by the owners of a business to buy the warehouse, factory or office premises from where their firm operates; or to re-mortgage an existing loan on more favourable terms.
They can also be taken as an investment on a ‘buy-to-let’ basis, where borrowers rent the building they’ve purchased out to a business (although in this case the lender may restrict the type of tenants you can have). However, they differ from residential mortgages in that they can also be used for other things.
For example, you can use commercial mortgages to buy a going concern (which might well include a property) such as a farm, pub, restaurant or care home. They can be used to part fund a management buyout or corporate acquisition, or even to simply raise some additional working capital to help take your business forward.
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Commercial mortgages are often the best way to finance the purchase of land and/or buildings for your business. Instead of raising funds by selling an interest in your business to an investor who will expect a percentage of your company and its profits in return, you’ll retain 100 per cent ownership of your business and acquire what is potentially an appreciating asset.
Although obviously lenders are entitled to interest on the loan, provided you don’t default, they cannot take a stake in your business. Repayments on a mortgage are likely to be similar to rental payments. By buying instead of renting, especially if you opt for fixed rate loan (see below), you’ll be protected against any hefty rent rises and you’ll be able to sub-let any free space that you might have (although you will almost certainly require permission from your lender to do so).
You will also have the opportunity to build extensions and make conversions to your premises.Your cash flow should improve as a mortgage gives you immediate access to funds with relatively low set-up costs and you can use that cash for other, more pressing, needs. As mortgage repayment schedules are agreed in advance, and can also sometimes be flexible, it should be easier to manage your budget. Interest payments on commercial mortgages, like other loans solely for business use, are also tax deductible.
Unfortunately, there are also drawbacks. Unlike renting, you'll need to come up with a substantial deposit. Typically you can borrow up to around 75 per cent of the property’s value, although you may find a lender prepared to lend more subject to a higher interest rate or increased security.
If you plan to rent out the property, lenders will look at the projected rental income to assess the maximum loan-to-value. A typical ratio is 130 per cent, meaning the annual rental return should be 130 per cent of the commercial mortgage payments.
If you own premises but with a mortgage, this means that you are much more tied down than if you are renting the premises. This can be important if you think you may need to relocate. Clearly, it is likely to be less hassle to end a rental agreement than to have to sell your premises, or find a tenant to rent them from you, so that you can move elsewhere.
Although you won’t face hikes in rent that are outside your control, you will be exposed to increases in interest rates, a pertinent factor in today’s economic climate. Being a property owner also carries with it certain responsibilities, such as maintenance, fixtures and fittings, insurance and security.
Types of commercial mortgage
Commercial mortgages tend to be repayment loans - usually over 15 or 20 years, if it’s a new property, rather than the standard 25 years on residential loans. However, choices in commercial mortgages are increasingly mirroring those for residential borrowers, meaning that the following options are available if you shop around:
- Flexible mortgage – this is part overdraft, part repayment mortgage. An agreed percentage of the loan is available as a ‘drawdown’ arrangement, meaning businesses can take ‘tranches’ of money as and when they need it, but only have to pay interest on the actual amount used, not on the total facility.
- Repayment mortgage – a traditional repayment mortgage, where regular instalments comprise interest and capital repayments.
- Interest only mortgage – another traditional style mortgage, where repayments comprise interest only, with the capital being paid back in a lump sum at the end of the term. Obviously, businesses need a strategy to raise sufficient cash to do this when the time comes.
- Repayment mortgage, with balloon payment – this type of mortgage requires you to make equal monthly payments of capital and interest for a relatively short period of time. After you make the last instalment payment, you must pay the balance in one payment, called a balloon payment. Some lenders will give you the option to refinance the mortgage to help you stretch out the final balloon payment.
This can be a real boon because it means lower monthly payments during the course of the mortgage, freeing up cash for other things. However, it can lull you into a false sense of security, as it’s tempting to forget the big balloon payment waiting around the corner.
The pricing of commercial mortgages is more complicated than in the residential market, and there are a number of different criteria used by lenders for setting the interest rate you’ll pay.
The rate will depend on many factors, not just current interest rates. For example, your own credit history (and that of any tenant, if you are letting the property), the past and projected performance of your business, the security you can offer, and general conditions within your particular industry sector will all be taken into account.
You will probably still have the option of either a fixed or variable rate. With a fixed rate, the interest rate will be fixed for a predetermined period that may or may not equal the length of your mortgage. Obviously, the advantage of a fixed rate loan is that you’ll know exactly what your repayments will be for the duration of the fixed period. However, if rates fall, you’ll lose out. At the end of the fixed rate period you can generally revert to the standard variable rate or negotiate another fixed rate for a set number of years.
Variable interest rates are more common and generally link your repayments to either bank base rate or Libor (the wholesale money market rate). Commercial mortgages tend to be between 1.75 per cent and 3 per cent over base rate.
You might also be able to borrow at a ‘capped rate’ meaning the variable rate cannot rise above a pre-determined limit for an agreed period (usually no more than 5 years), after which it reverts to the standard variable, or a ‘cap and collar’ rate, which has both a ‘ceiling’ and a minimum rate that interest cannot fall below.
Generally speaking, you can initially get a lower interest rate on variable interest rate mortgage than on a fixed rate mortgage.
Who's liable for loan repayments?
Liability for repayment of the loan depends on the legal structure of your business. If you are a sole trader you will be personally liable for the mortgage debt, and you should be aware that your personal assets may be seized if the business defaults. If you are in a partnership, then you and your partners are jointly and severally liable for any debts the partnership incurs, and again your personal assets are potentially at risk.
With a limited-liability partnership and a limited company, where liability falls firstly on the business, rather than on the individual partners and directors, a lender may take a floating charge on business assets in general, rather than simply on the current property being purchased. The lender may also insist on personal guarantees as a condition of granting the loan, in which case the partners and directors can still be held personally liable.
How to apply for a commercial mortgage
If you would like to buy your business premises, whether you are an established business or a start up, a good place to start is your bank, assuming you have a good relationship with it.
Most high street banks provide commercial mortgages, and building societies, such as Norwich & Peterborough.
When you apply, be prepared to demonstrate that you will be able to repay the mortgage. The property will in itself be some security, but your lender will still want to see three years of audited accounts (profit-and-loss, balance sheet, cash-flow forecast), an accountant's certificate testifying to the financial state of the business and possibly a business plan.
The lender may ask for personal financial details of any partners and co-owners and will use this information to judge your creditworthiness and your ability to maintain and grow the business.
Where there are insufficient accounts or other deficiencies (for example the lender thinks you are inexperienced), you might still be lucky enough to get your loan, but the price may be higher and you might face stricter terms and conditions.
Also expect the lender to arrange for a valuation of the property, and also potentially require a survey (always good idea if you are planning to buy any property), which you will be expected to pay for, and which will be more expensive than a residential valuation. You might also be expected to take out life insurance as a condition of the loan.
Other things to look out for
You’ll probably have to pay an arrangement fee, typically between 0.75 per cent and 1.25 per cent. Legal costs will also be higher as commercial property transactions tend to be more complex than residential ones and there may be a completion fee as well. Beware of early repayment penalties. If your new business venture is a rip-roaring success and you want to retire after a couple of years, you don’t want to have to pay an early redemption fee before heading off into the sunset.
At the other end of the spectrum, should you experience difficulties, it’s may be a good idea to negotiate a ‘grace’ period, for example if your monthly payment is due on the first day of each month, ask your lender to allow you until, say, 7th before the payment is deemed to be late.
With a commercial mortgage, a potential lender will seek information pertaining to both the business and the individuals who run the business and who are applying for the loan on its behalf.
The lender seeks evidence that the business can pay the interest and repay the principal (the amount borrowed) according to the agreed repayment schedule. Each commercial loan will be tailored to the characteristics of the business.
“Repaymentability is the key criterion for most lenders,” says Steve Nicolls of A to Z Financial Intermediaries of Potters Bar. “Lenders do not like to get involved in the practicalities of selling a repossessed property because it is not their core business. And they do not like being involved in too many forced sales lest they are perceived as irresponsible lenders.”
The lender will demand a rate of interest that reflects the commercial risk that is judged to apply to the particular enterprise. Likewise, the lender may insist that the principal is repaid regularly over the life of the mortgage rather than by way of a balloon payment after a given period.
The lender will seek information in respect of the following:
1. Business history: The lender will want to see three years of audited accounts (profit-and-loss, balance sheet, cash-flow forecast), an accountant's certificate testifying to the financial state of the business and possibly a business plan.
The lender may evaluate the cash-flow forecast and the business plan against the known performance of enterprises of a similar kind and in the same location.
Where there are insufficient accounts or other deficiencies (e.g. insufficient experience as judged by the lender), the lender may still agree to make the advance, but subject to a higher interest rate and stiffer terms and conditions.
2. Loan-to-Value is typically around a limit of 75% but the lender may go higher subject to a higher interest rate and/or additional security.
The lender will base the maximum advance on the average retained profit after allowing for existing debt, exceptional charges and depreciation (i.e. money charged to the profit-and-loss account for the replacement of productive assets). The basic criterion is that business profits should cover interest payments by a suitable margin (e.g. 130%).
3. Loan Term: The business can usually borrow for terms up to 25 years, depending on whether the property is leasehold or freehold. In the case of a leasehold property, the commercial mortgage term may be affected by the length of the lease.
4. Personal details: The lender may ask for financial data pertaining to the individuals applying for the loan on behalf of the business. The lender will use this information to judge the ability of the individuals to carry out the business plan as well as to check on their probity.
Certain lenders may agree to advance commercial mortgages to business controlled by individuals with adverse personal credit histories, but at a cost.
Last edited July 2007