What is the difference between business owners who own
their building and business owners who rent their building?
The ones who own their building have two sources of wealth
generation: their business and their commercial property.
The simple economics of land ownership - finite supply and
increasing demand - often means the commercial real estate
holdings have a significant positive impact on the ultimate
return of the business.
But it's not just cashing out where real estate can make a
difference. The combination of declining loan balances and
(hopefully) advancing property values means that
entrepreneurs can build equity. This equity represents a
valuable resource in their small business tool kit. Unlike
their competitors without real estate holdings, they can
borrow against the equity in their property to fund new
initiatives, expansion and the acquisition of additional
properties or businesses. And they can do this without
diluting the ownership in their own company.
But this flexibility comes with a price. Lenders who lend
against real estate must protect themselves against the
risk that the loan - despite the best intentions and
efforts of the principals - may run into trouble and not
pay off through cash flow from the business, but rather
through the outright sale of the property. What this means
is that while you may have $300,000 of equity in a
property, lenders cannot lend against the full value of the
equity. In fact, they can only lend against a portion of
the equity.
Because the lender must take into account a worst case
scenario - either because they are a fiduciary lending
funds from another investor, or because they must preserve
their own capital against loss - the question becomes, how
does a real estate lender view your commercial building?
Knowing the lender's perspective in property valuation will
help you understand some of the thinking behind your
lender's terms, and perhaps provides some purchase points
for negotiation on the loan-to-value ratio (LTV). This LTV
represents the amount of equity you can borrow against, and
as such is the single most important determinant of the
funds that you can access through the equity in your
commercial property.
Elements of Comparison Typically, commercial lenders which
use real estate as collateral look at comparable sales, and
adjust their findings with so called elements of comparison
and an assessment of the property's marketability.
First, let's look at comparable sales and elements of
comparison. Just like any buyer, the lender will look at
sales of comparable properties in the surrounding area.
Then the question becomes, does the would-be borrower's
property seem to be worth more or less?
You've heard the old real estate saw: Location, Location,
Location. When lenders look at a commercial building as
collateral, this is perhaps their first consideration.
There are elements of location that add value and there are
elements that subtract value.
A central business district location is better than one in
a remote area. A corner location is often more desirable
because it generally gets twice the traffic than a locale
adjacent to two other buildings. A building on a one way
street will see less traffic than one that is not. At the
same time, a building that has no street frontage would be
viewed by a real estate lender as less valuable than one
that did.
Another important element of comparison is land area in
relation to the building and the enterprise. For instance,
a building that covers most of it's land area with little
or no parking would not compare as favorably to a building
that had more parking, or a loading dock, or room to expand
the building. While some businesses would not need these
amenities - such as a small manufacturer, or a repair shop
- in the lender's eye, diminished land area limits the
number of would be buyers in a liquidation scenario, and as
a result, reduces value.
A third important element of comparison is the overall size
of the building. Again, this is a relative comparison to
the property type. If your building houses your auto repair
shop with three bays, while most other independent repair
shops have between four and six bays, your property would
be considered small, which would have an impact on it's
value in the eyes of the lender. By the same token,
buildings that are large by comparison pose challenges too.
A building used for dry cleaning that is three times the
size of a typical dry cleaner would be viewed by a lender
as less desirable than one that was typically-sized.
Marketability The elements of comparison hold little
intrinsic value. Their real meaning comes from how they
influence the marketability of a property.
Remember, if a lender ends up as the owner of a building,
it's not by choice, but literally by default. This means
the lender will seek to sell the building in a reasonable
period of time. While many lenders want to avoid the losses
that can come with a very quick sale, they do not want to
own a building over a prolonged period of time, where
taxes, maintenance, and unforeseen events can have a
material impact on their ability to recover the principal
balance of the loan. Generally speaking the maximum time
period which a lender will want to own a building is
between six and 12 months.
The correlation between marketability and the loan-to-value
ratios runs inversely. That is, the longer it appears it
will take to sell a building, the smaller the amount the
lender will advance against a building owner's equity.
Thus, the commercial lender's focus on elements of
comparison and marketability are closely intertwined.
Specifically, buildings with unfavorable elements of
comparison take the longest to sell, and as a result pose
more risk for the lender. The lender mitigates this risk
with a lower loan-to-value ratio.
Who Loves Ya? For borrowers that have single purpose
commercial properties, the lenders' approaches toward
property valuation can prove frustrating. From a lender's
point of view, the dedicated purpose of the building does
not add value, but rather shrinks it, because there is a
smaller pool of buyers, which in turn increases the time
that may be required to market the property. Some lenders
will not even consider such a property as collateral.
Small business borrowers seeking loans backed by
owner-occupied commercial real estate may find
nontraditional lenders more willing to strike a deal, or
seek creative solutions to get a deal done.
There are two reasons for this.
First, traditional lenders have dramatically increased
minimum loan amounts. Many want to make loans no less than
$1 million. This is a difficult proposition for a business
owner with $300,000 to $400,000 in equity looking for a
$250,000 loan. Second, most bank lenders avoid loans where
the underlying property to be used as collateral has a
single use, or which may have one or two unfavorable points
of comparison. The rigidity of their underwriting process
and the size of their existing franchise often precludes
them from taking risks they don't have to. Rightly or not,
their attitude is often something akin to, 'Why should we?'
Nontraditional lenders, by comparison are more niche
oriented. Whereas banks see the market for small businesses
loans of less than $1 million as, well, small, and rife
with irregularities, non bank lenders may see more
opportunity. Accordingly, they are more willing to consider
unique properties and willing take more time to structure a
deal which fits the needs of the borrower, yet still
mitigates their risk.
While the best lender for you is the one that can put
together a loan package that suits your needs, borrowers
should carefully consider the points mentioned above. They
will help narrow the search and reduce the time it may take
to get to the closing table. And remember, it's not just
getting one deal done. Firms that are anxious for your
business, and which are built to take it on, represent the
kind of lender that can help you not just once, but time
and again as you continue to build your business and your
own personal wealth.
----------------------------------------------------
Paul Kelly has introduced the "SNAP COMMERCIAL" Loan System
that focuses on small balance commercial loans that require
a minimum of paperwork from evaluation to funding. He can
be reached at (323) 353-8655,via email at
paul@snapcommercial.com or at his website
http://snapcommercial.com .
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