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Overview
A commercial mortgage is most likely the best way to
finance the purchase of land and/or buildings for your
business! It probably provides the most flexible and
affordable financing solution. A commercial mortgage is
a specialized commercial loan in which the lender has a
legal claim over the property until the loan has fully
been repaid. When arranging a mortgage, consider its
effects on your cash flow and assets. This section will
give you a general overview. It does not replace
professional advice. You may wish to consult your
accounting and tax advisors before finalising a loan to
reap the maximum benefit and avoid complications
How It Works
Mortgages may be structured several different ways but
the two most important aspects to consider are the
interest rate (type) and the repayment schedule for the
mortgage. There are two interest rate options for
you to consider:
- Fixed Rate: With a fixed rate the
interest rate (i.e. the percentage) applied to the
outstanding principal remains constant through out a
predetermined period that may or may not equal the
length of your mortgage. The interest rate is set at
the beginning of your mortgage by examining the risk
involved and the current market rates. The advantage
of a fixed rate loan is that your interest rate is
fixed and will not rise if the market rate rises.
The disadvantage is that you will not benefit from
any reduction of the market rate.
- Variable Interest Rate: With a variable
interest rate the interest rate applied on the
outstanding principal fluctuates in line with
changes to the Bank Base Rate or LIBOR and, as a
result, so will the amount of your payments. The
interest rate for each period will be the current
market rate plus a predetermined premium that
remains constant throughout the life of your
mortgage. Generally, you can initially get a lower
interest rate on variable interest rate than on a
fixed rate mortgage. The advantage of an adjustable
interest rate mortgage is that you save money when
the market rate decreases. The disadvantage is that
you are not protected from an increase in the market
rate and the interest rate you pay will increase
with the market rate.
When deciding on your repayment schedule you
should always remember the longer you take to payback
the principal the higher your total interest payment
will be.
- "Equal" Payments: Probably the most
common schedule, this type of mortgage requires you
to pay the same amount each period (monthly or
quarterly) for a specified number of periods. Part
of each payment covers the interest and the rest
reduces the principal.
- "Equal" Payment and a Final Balloon Payment:
This type of mortgage requires you to make equal
monthly payments of principal 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 type of mortgage offers definite benefits to
you. Because of the lower monthly payments during
the course of the mortgage, you can keep more cash
available for other needs. Of course, when you are
thinking about those nice low payments, don't forget
the big balloon payment waiting around the corner.
- Interest-Only Payments and a Final Balloon
Payment: With this type of mortgage, your
regular payments cover only interest. The principal
stays the same. At the end of the mortgage term, you
must make a balloon payment to cover the entire
principal and any remaining interest. The obvious
advantage of this arrangement is the low periodic
payments. But over the long term, you will pay more
interest because you are not reducing the principal
sum on which you pay interest.
- Endowment Mortgage: This type of mortgage
is similar to an interest-only mortgage but the
repayment of the principal comes from the proceeds
of an endowment. Several types of endowments are
eligible for this type of mortgage, they include:
life assurance policy, personal or executive pension
plan policy, or a personal equity plan. The
additional security provided by the endowment
usually result in a lower interest rate.
Advantages
- Retain Ownership. Instead of raising
funds by selling an interest in the property or the
business to an investor, you retain complete
ownership of both. The lender is only entitled to an
interest return on its mortgage, not a percentage of
ownership that an investor would expect. Also he/she
can only exercise the right if you default. You
retain all the benefits of ownership in an asset
that has the potential to appreciate in value.
- Better Cash Flow. A mortgage gives you
access to capital with minimal up-front payments and
the flexibility to design a repayment schedule that
suits your needs.
- Maximize Financial Leverage. Financing
your property purchase with a mortgage will allow
you to use your cash flow for other pressing needs.
- Simplified cash flow management. Mortgage
schedules are preset, making cash management more
predictable.
- Tax advantage. Interest payments on your
mortgage are tax deductible and are made with
pre-tax money. Purchases financed with profits, in
contrast, are, made with after-tax money.
Disadvantages
- Collateral. The nature of a mortgage
requires you to pledge the purchased property to the
lender. If you default on the mortgage, the lender
is able to foreclose upon the property and sell it
to repay the money owed to the lender. Make sure
that when the mortgage is repaid, the lender is
obligated to release its mortgage and is required to
make any government filings acknowledging this
release.
- Defaults. The lender may define a variety
of events that will constitute a default on the
mortgage, including failure to make any payment on
time, bankruptcy, insolvency and breaches of any
obligations in the mortgage documents. Try to
negotiate advance written notice of any alleged
default, with a reasonable amount of time to cure
the default.
Things to Watch out for
- Mortgage fees. The lender may charge
up-front loan or processing fees. Check these fees
carefully, and try to get an estimate as soon as
possible to help you evaluate the mortgage package.
- Prepayment. Ideally, you want to be free
to pay off the mortgage (all or in part) at any time
before its due date. Unfortunately the majority of
lenders are likely to charge a redemption penalty in
the first 3 to 5 years of the mortgage. But after
that initial period, you should make sure that your
mortgage agreement gives you this flexibility and
try to avoid a prepayment penalty for paying off the
mortgage or part of the mortgage early.
- Grace period. Try to get a grace period
for any payments. For example, the monthly payments
may come due on the first day of each month, but
they won't be deemed late until the fifth day of the
month.
- Sale and leaseback. An alternative to
mortgaging a property is to enter a sale and
leaseback. In this transaction, you would sell the
property to a buyer, who would immediately lease the
property back to you. In this situation the main
advantage is that the buyer would be required to
find the financing for the purchase. However you
have sold your ownership of the property and you
would not share in its appreciation.
- Legal and Professional Fees. Before you
finalize your purchase and ownership of the property
passes to you, you will incur several closing costs
above and beyond the cost of the property and fees
arranging for the mortgage. Common expenses to be
paid at closing are title insurance, the site survey
fee and various fees for preparing the legal
documents.
Frequently Asked Questions (FAQs)
Q. Why should I purchase property instead of letting?
A.
Purchasing property is a large decision for any
business. There are several advantages and disadvantages
that should be considered before making your decision.
Advantages include:
- Fixing your overhead costs. When you
finance your purchase with a mortgage you have a
repayment schedule that sets your fixed expense each
month.
- Potential asset appreciation.
- Potential to sublet. If you purchase more
space than your company currently needs, you could
sublet a portion of it until you need the space.
- Mortgage payments may be cheaper then rent.
When you set your repayment schedule you know what
your payments will be in advance. When you rent your
property, you are exposed to market conditions that
may increase your rent to above what your mortgage
payments would have been.
Disadvantages include:
- Harder to relocate. If you have a lease
and decide to change locations the process is
relatively simple. When you own the property, you
need to determine if you should sell the land or
find a new tenant.
- Drain on cash. A mortgage will not
provide 100% of the financing needed to acquire the
property. You will need to use your current cash to
finance a down payment and pay for any related
expenses.
- More management responsibilities. When
you let the property, the landlord is responsible
for the upkeep and security of the property.
Q. What is the usual length of a mortgage?
A.
Mortgages are typically available for any time
period between 5 to 25 years. For commercial mortgages
the maximum length of the mortgage is usually 20 years
for newer properties and 15 years for older properties.
Q. How much cash do I need to provide for a down
payment?
A.
Typically lenders often view mortgages with
larger down payments as more secure. Most lenders
typically like to receive 20% to 30% of the purchase
price as a down payment. Depending on your company's
financial history, as little as 5% of the purchase price
may be required for a down payment. (You will most
likely have to pay a higher interest rate to compensate
for the smaller down payment). You should remember, that
the larger your down payment is, the less you have to
borrow.
Q. How should the mortgage be structured?
A.
If possible, you should form a separate business
entity to lease the building to your operating company.
This separate entity should then arrange for a
non-recourse mortgage for the purchase of the property.
This should protect your operating business if you
default on the mortgage. You may wish to consult your
accountant or tax advisor.
Q. How can I improve my chances of getting a
mortgage?
A.
Be prepared to demonstrate why you have a solid
chance of repaying the mortgage. The lien on your
property adds security but the lender will still base
their decision on your ability to repay the mortgage. It
will be extremely beneficial to be able to show the
lender a history of your earnings and a projection of
future earnings. Also expect the lender to arrange for a
property appraiser to estimate the market value of the
property; this will help the lender feel that the
property is sufficient collateral for the mortgage.
Q. Who is responsible for the repayment of the
mortgage?
A.
The legal structure of your company will
determine who is responsible for the repayment of the
mortgage and who will be liable if it is not repaid. If
you are a sole trader, you bear all the responsibility
and potential liability. If you have formed a
partnership, all of the partners involved are jointly
and individually responsible. If you are a legal
company, the Directors may be liable if the mortgage is
not repaid.
Glossary
Asset - Any item of economic
value owned by you or your corporation, especially that
which could be converted to cash.
Bank Base Rate - The minimum interest
rate that the bank will charge you for your loan.
Collateral - Asset pledged by a
borrower to secure mortgage. The asset is subject to
seizure in the event of default.
Discount Points - Type of fee that you
pay to the lender. One point is equal to one percent of
the of the loan amount.
Down Payment - Part of the purchase
price that the buyer pays in cash and does not finance
with a mortgage.
Endowment - A fund owned by an
individual that is to be used for a specific purpose.
Fixed Rate - The interest rate (i.e.
the percentage) applied to the outstanding principal
remains constant throughout the life of the loan.
Lender - A financial entity that makes
funds available to others to borrow.
LIBOR - London Inter-Bank Offer Rate is
the interest rate that the largest international banks
charge each other for loans.
Lien - A legal claim against an
asset that is used to secure a mortgage. To sell the
property, the lien must be paid.
Principal - The amount borrowed
from the lender.
Outstanding Principal - The
amount borrowed from the lender that remains unpaid
(this excludes interest outstanding).
Recourse Mortgage - A mortgage
for which another company (usually the parent) is
responsible for payments if the original borrower
defaults on the mortgage.
Repayment Schedule - A listing of the
amount of principal and interest, due dates and balance
after payment for a given mortgage.
Terms - The specific condition and
details of an agreement or contract.
Variable Rate - The interest
rate (i.e. the percentage) applied on the outstanding
principal amount fluctuates from period to period.
Working Capital - The amount of
funds in the business required to finance the day-to-day
operations of the business.
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