As a business owner, location can be a key to success. Unless you are working out of your home or garage, you probably didn’t start your business in a building that you own. Most likely, you leased the location.
Renting a Building for your Business
Rent is a variable expense. While low rent is a plus, high or suddenly raised rent can be a burden. There is also the risk that your congenial relationship with your current landlord may not continue with the new one when and if the current owner sells the building. Now, let’s talk about equity, or lack thereof. Rental payments are purely expense items, and if you are paying your landlord “triple net lease,” you’re paying the real estate taxes as well. As your business grows and you are able to retain earnings, it might be a good time to think about purchasing a building. Over the past several years, the combination of lower real estate prices and lower mortgage interest rates have created an environment where it is often less expensive to pay a mortgage and real estate taxes on a property than it is to rent one. This trend will not last forever. Before we talk about how it’s done, let’s discuss some of the benefits.
Four Benefits of Owning Your Own Building
First, as landlord for your company, you control your lease and rent expense. Second, the building and land should appreciate in value over time, adding to you and your company’s net worth. Third are the tax advantages of real estate ownership. Fourth, if you lease some of the space, you now have another source of income in the form of rent. Before you make a decision, it is a good idea to talk it over with your CPA. Your attorney can also provide some very useful guidance about optimizing the purchase to fit your needs and risk appetite, once you have decided to buy.
Considerations for Buying
Let’s say that you’ve had the conversation with your CPA and have made the decision to buy. Since most of us do not have a lump sum of cash available to buy a building outright, a commercial mortgage is worth considering. Let’s talk about the various options. First, are you planning to be the sole occupant of the building, or will you have tenants? This is important because the amount of space you plan to occupy will determine the percentage you can borrow against that purchase price. For example, if you are occupying more than 50% of the space, your building would be considered an owner occupied property and therefore would qualify for a lower down payment. At Webster Bank, for example we would finance up to 80% of the purchase price or appraised value, whichever is less.If you plan to occupy less then 50% of the space, the property is considered an investment property, and would require a higher down payment. At Webster, the down payment on investment property is usually 25%. Other lenders may require as much as 35%.
Terms of Commercial Mortgages
Many banks mature their commercial mortgages at 5, 7 or 10 year periods. This is how it works: For example, you have a 20-year mortgage. When that maturity comes due at year 7, you will need to refinance the balance of the mortgage at that point or pay it off. This is a very expensive and risky process, and will always include variables and costs such as a new appraisal. Worse, your current lender might decide they do not want to refinance the loan at all. Webster Bank does not mature mortgages with amortization schedules up to 20 years. If a 25 year amortization is requested and approved, the maturity date on those mortgages would be 10 years.
Commercial Mortgage Interest Rates
Second consideration is mortgage interest rates. Unlike residential mortgages, which are primarily sold off in the secondary market, most commercial mortgages remain on the bank’s balance sheets and this means that rates cannot be locked in for 30 years. Many banks offer a floating rate option as well as 3, 5, 7 and 10 year fixed rate options. One of the key questions to ask besides your rate is the index. The index is the base which the bank uses to establish your rate. Some banks use treasury yields, other use Federal Home Loan Bank yields. With this index, the bank adds a margin so the index plus the margin equals your rate. The margin is key as it will affect your rate now and all those adjustment periods. Banks charge a range of margin from 3.25% over the index to a low of under 2.00%. There are many factors that go into your particular overall interest rate, such as risk, your deposit balances, and the competition, etc.
For those with commercial mortgages, refinancing is a frequently-asked question. Some of the variables that come into play are, first, how high is your interest rate now and how much better can you do? A good rule of thumb to wait until you can find a rate that is at least 2% lower than the rate you are now paying. Interest rates are just one piece of the puzzle -- there is also the Term you have to consider. If you have more then 7 years left on the mortgage and you can get a much lower rate, you might be in a good position to refinance. Other factors include prepayment penalties. Do you have one with your current mortgage? If so, how much will it cost you to pay it off? If the rate and terms are good, you might be in a position to borrow some additional cash above your current mortgage balance and use it for building repairs or working capital for your company. Interest rates are at historic lows right now, and it might be time for you to buy. Before you act, be sure to sit down with your CPA and your banker and determine whether the numbers make sense. If you have any questions, please call me or post them, below.