In a rising interest rate environment, the cost of capital is edging higher for all small businesses, but especially those who need to purchase property. As a result, U.S. entrepreneurs are returning to banks in large numbers seeking to finance real estate projects.
In many respects the current business climate is perfect for an uptick in small business lending. Business optimism has reached its highest since July 2007, according to the Wells Fargo/Gallup Small Business Index, with a reading of 100 in February, up from 80 in November and 33 points higher than a year ago. Business owners are taking advantage of a better financial situation, enjoying increasing revenue, stronger cash flow and improving access to credit. Since the 2008 financial crisis, small business owners have relied heavily on loans with adjustable interest rates. After all, interest rates were near zero for almost a decade. Now that’s changing. The U.S. Federal Reserve in March increased interest rates for the third time since the financial crisis. While the Fed’s benchmark rate remains at a very low level, below 1 percent, the average interest rate on a 30-year mortgage has risen a half a percentage point higher over the last year, as has the U.S. Prime Rate, the benchmark rate for many small business loans.
Small business owners seeking to finance real estate mortgage loans, ranging from as little as $150,000 to as much as $20 million, have three basic choices.
Conventional commercial mortgages
The cheapest financing option available to small businesses are conventional mortgages. Banks will consider a conventional mortgage for a well-established firm with a predictable revenue stream. Business owners will need a down payment of at least 20 percent for a general use building, such as an office or warehouse building. For specialized-use building, such as a bowling alley or a hotel facility, banks prefer deposits of 30 percent. Startups without profits and firms less than two years old will generally not qualify for conventional loans.
These loans typically have terms of three to 10 years with payments based on a 20- or 25-year amortization and carry interest rates (today these are generally in the mid-4 to mid-5 percent range for most borrowers) that are fixed on the shorter term loans, but adjust after five years on the longer term loans. At the end of their term, these loans typically need to be refinanced into a new loan, which means you have the added costs of new appraisals, environmental reports and loan fees each time they refinance.
The 7(a) loan program
The Small Business Administration’s most popular loan has dominated lending while interest rates have been near zero. These flexible loans typically have an interest rate of up to Wall Street Journal Prime Rate plus 2.75 percent. Today that’s equal to 6.75 percent.
Borrowers can prepay the loans up to 25 percent each year for the first three years without penalty; and after that they can prepay as fast as they want without penalty. The interest rates on these loans often adjust quarterly, so rates will rise with each Fed move. On the other hand, monthly payments are kept lower because these loans have a term of up to 25-years. Businesses can put down a deposit of as little as 10 percent, although loans that exceed 85 percent of the property’s value may require additional collateral.
These loans are especially helpful for younger companies and rapidly growing companies that have cash constraints, but they have the added advantage of never needing to be refinanced and provide low-cost prepayment options for firms that want the option to repay early.
A certified development company/504 loan:
These hybrid loans blend a bank conventional first mortgage with an SBA-guaranteed bond in a second lien position. The bank portion covers 50 percent of the financing need and is typically an adjustable-rate mortgage similar to the conventional commercial mortgages described above (currently available with rates between 4.5-5.5 percent adjusting every five years depending on the strength of the borrower and the deal). This is married with the SBA-guaranteed bond which covers 30-40 percent of the financing need from a fully-amortizing note (currently with a 4.9 percent fixed rate for 20-years.) Businesses put down a 10 percent deposit if they are mature businesses, 15 percent if they are less than two years old or if it’s a specialized-use building, and 20 percent if the business is less than two years old and it’s a specialized-use building.
These loans have the advantage of partially fixed interest rates and a bond that never has to be refinanced from the SBA, and a competitively priced bank loan that will likely need to be refinanced at its maturity in 10 years. The SBA-guaranteed bond has a declining prepayment penalty, which is around 3 percent today and is tied to the interest rate on the SBA portion. The bank loan may have its own prepayment penalties.
Borrowers concerned about rising interest rates and wondering which option is best for them should consult with their business planning team and their local SBA banker.
Simply put, conventional mortgages will have the lowest monthly repayment but the highest down-payment; 7(a) loans are best for newer companies and rapidly growing companies that need to preserve capital for growth or never want to have to deal with a refinance; 504 loans offer some of the same advantages that 7(a) loans offer, but add long-term interest rate protection, so they tend to work best for growing firms that want more interest rate predictability in a rising rate environment.
However, before proceeding with any loan, the first question I ask any business owner considering taking on debt is, “Do you really need a real estate loan?” Renting property is often the best solution for companies that need the flexibility to scale up and down in size, either seasonally or with the business cycle. Business owners should also consider if investing in real estate will produce the best return on their capital. If better yields are available by buying equipment or investing in the growth of their business, that’s a good reason to put the lowest down payment possible on any mortgage and put the rest of your available capital to work growing your company. Not all banks are the same. Some may not offer SBA loans while others only offer select programs. Business owners should make sure they understand all of their options before making the decision on the best financing for their real estate purchase.
The sense of urgency among small business owners to take loans has spiked after the election of a new U.S. president and as interest rates rise. Still, smart business owners will take their time to consider their options before lining up their long-term financing.