If you have never borrowed money for your business before, you may be in for a surprise. Whether you want to borrow working capital to expand your business or leverage equity in a commercial real estate venture, you will soon find out the commercial loan process is very different from the more common home mortgage process. Commercial loans, unlike the vast majority of residential mortgages, are not ultimately backed by a governmental entity such as Fannie Mae. Consequently, most commercial lenders are risk-averse; they charge higher interests rate than on a comparable home loan. Some lenders go a step further, scrutinizing the borrower’s business as well as the commercial property that will serve as collateral for the loan. This means that the business borrower should have different expectations when applying for a loan against his commercial property than he would have for a loan secured by his or her primary residence.
Following is a list of questions the borrower should ask himself and the lender before applying for a commercial loan.
Typically, bank loans require the borrower to repay his or her entire business loan much earlier than its stated due date. Banks do this by requiring most of their loans to include a balloon repayment. This means the borrower will pay interest and principal on his 30-year mortgage at the stated interest rate for the first few years (generally 3, 5 or 10 years) and then repay the entire balance in one balloon payment.
Many borrowers do not save enough in such a short time frame, so they must either re-qualify for their loan or refinance the loan at the end of the balloon term. If the business happens to have any cash-flow problems in the years immediately preceding the balloon term, the lender may require a higher interest rate, or the borrower may not qualify for a loan at all. If this happens, the borrower runs the risk of being turned down for financing altogether and the property may be in jeopardy of foreclosure.
A balloon loan has other risks as well. If the borrower’s business is in a “risky” industry at the time the balloon is due (think of the oil and gas bust in the 1980s or the telecom implosion of the 2000s), the lender may back out of all refinancing for the enterprise. Alternatively, a lender simply may decide its loan portfolio has too many loans in a given industry, so he will deny future refinancing within that trade.
Non-bank lenders generally offer less stringent credit requirements for commercial loans. Some non-bank lenders will make long-term commercial loans without requiring the early balloon repayment. These loans, which may carry a slightly higher interest rate, work like a typical home loan. They allow a steady repayment over twenty or thirty years. It is often worth paying a one- or two-point higher interest rate for a fixed-term loan in order to ensure the security of a long-term loan commitment.
Most bank loans prohibit second mortgages, so the borrower should go into the loan process intending to borrow enough to meet current business needs, or enough to sufficiently leverage real estate investments. For a traditional acquisition loan in which the borrower is buying a new property, banks usually require a down payment of 20-25%. So for a $600,000 acquisition, the borrower will need to come up with $120,000-$150,000 for the down payment.
Some non-traditional loans will allow the borrower to make a smaller down payment, maximizing the loan-to-value (LTV) at 85-90%. Such loans are generally not bank loans, but are offered by direct commercial lenders or pools of commercial investors. If the customer wants to borrow the maximum amount possible, the interest rate on such loans may be a point or two higher than typical bank loans. Before deciding how much to borrow, potential borrowers should:
Research has consistently shown that the number one reason behind the failures of most small businesses is the lack of adequate capital to meet cash-flow needs. Because of this it may actually be safer for a small business to leave a larger cushion against unforeseen events by borrowing more money at the slightly higher rate.
The amount of the loan requested has an effect on which commercial lenders will fund the loan. Small businesses borrowing less than $2,000,000 will visit a different pool of potential lenders than those seeking loans of over $5 million. Small business loans are generally made by direct commercial lenders (easily located by internet searches) or by small local banks. Larger loans are generally made by regional banks, and very large loans are made by mega-banks or Wall Street lenders.
Borrowers generally start the loan process by contacting their bank. Unfortunately, it is difficult to secure business loans from most banks. Besides, bank loans:
Bank loans go through several phases of review. First, they will look at your historical income statements, balance sheets and statements of cash flow. Then they will review 5 years of tax returns on the borrower and all owners who will guarantee the loan.
Generally it takes several weeks before the borrower can get a verbal or written commitment letter from a bank. Even after the loan commitment, the bank’s credit committee may veto the loan. The business will then have to start the process over with a new lender. If a firm has very good credit rating, a good relationship with its bank, a solid and confirmable history of earnings and profits, and is not in a hurry, a local bank will probably give them the lowest stated interest rate on the loan.
If you need to be pre-qualified quickly, you should shop for credit over the Internet or look at non-bank sources of funds first. Once you secure a commitment from a direct lender, then you may start a parallel process with your bank. Some direct non-bank lenders can give you a verbal commitment in a few days, but keep in mind that you are only searching for “commercial” loans-offers from Internet companies may often be for residential property, so you will need to screen your searches.
Keep in mind the parameters of the terms you will accept: Will you take a balloon loan? What about a covenant or condition on the loan?
If you know that your profit and loss statements are not provable and solid, or you do not have a high credit score, applying at banks is generally a waste of time. Instead, go directly to non-bank commercial lenders.
Many borrowers are not aware that much more may be required than simply making regular monthly payments on time. Many loans ask you to provide quarterly or annual income statements, balance sheets and tax returns. Some loans will require covenants-promises that your business will meet certain tests in the future. They may require a certain positive cash flow, or a certain debt-to-cash-flow ratio, or other financial criteria. During a downturn in your industry or the economy, your business may face temporary cash flow or profit shortages.
If your business falls short of the terms and conditions contained in the loan covenants, your bank may deem that your loan has entered into default. Default triggers numerous penalties. It may require that you pay back the loan immediately. This can cause you to have to find another lender very quickly, or face foreclosure on the property.
Different lenders require different conditions, so ask the lender up front what conditions or covenants apply. Some non-bank loans charge a slightly higher interest rate but will waive all covenants and conditions except for timely repayment of the loan. If you feel that your business cash flow is uncertain, you might want to consider these non-bank loans first.
If your business does not have its financial statements certified regularly by one of the larger CPA firms, you may opt for a slightly higher interest rate loan. This may relax the reporting process or not require future covenants. Likewise, if losing your business or property to the bank is likely because of the financial test requirements, then find another lender. Ask any real estate developer who has managed to stay in the business for 20-30 years about the risks inherent with traditional bank commercial property loans; he will name many other developers who lost all their assets during lean times in the industry.
Traditional lenders require 3-5 years of financial statements, income tax returns, and other documentation. This may include:
Keep in mind that many small businesses do not have the level of income documentation some lenders require. If you ask ahead of time, it will save you numerous headaches from delays or rejected loan applications. The documentation required and the timelines for approval are related-the more information required, the slower the loan approval and funding process.
If your business booms, you may want to repay the loan early or sell the property and move to a larger space. Commercial mortgages, unlike residential loans, usually have pre-payment penalties. However, some lenders will allow the purchaser of the property to assume the mortgage by taking over the seller’s payments. An assumable loan is an excellent selling point, because it provides built-in financing for the buyer.
The stated interest rate is often artificially low when one considers all the costs of a loan. Points, for example, are direct percentages of the loan that the lender deducts from your loan. If your interest rate is 9% with two points that means your real cost of the loan is 11%. The extra 2% comes right off the top into the lender’s pockets. Other costs may include:
For some loans, these charges can be tens of thousands of dollars. They often must be pre-paid before the loan will be approved or rejected. You will need to know whether you are likely to be approved before spending money just to qualify for a commercial loan.
Other questions to ask
Some lenders allow for decreases in the interest rates over time if you pay the mortgage on time. But if you want to refinance and repay your mortgage early, the lender may penalize you and charge extra interest. All of these details are important, and they can seem overwhelming.
Keep in mind how you expect your business to perform in the future and how you plan to repay the loan. Do not ignore worst-case scenarios. You do not want to be so optimistic about the possibilities that you lose sight of the fact that the lender may take away your business or livelihood if you do not meet all the terms. Sometimes the lowest interest rates represent the riskiest loans.
The Best Lender
When considering a commercial mortgage, borrowers should seek out lenders who are willing to fund the loan under acceptable time constraints, keeping in mind their general creditworthiness. Borrowers should look at both bank and non-bank funding in order to get their needs met in a timely manner. Asking questions and obtaining unbiased evaluations will reduce delay and frustration. Fortunately, new lenders have emerged to challenge banks on their traditional terms, so borrowers have more leverage now than ever before when seeking commercial loans.