Commercial mortgages

A commercial mortgage is most likely the best way to finance the purchase of land and/or buildings for your business, as it probably provides the most flexible and affordable financing solution. A commercial mortgage is a specialised 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. You may wish to consult your accounting and tax advisors before finalising a loan to reap the maximum benefit and avoid complications.

Commercial 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 Interest 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 from in line with changes to the Bank of England 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 usually 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.

Commercial mortgage repayment options

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 and disadvantages of commercial mortgages

The main advantages of commercial mortgages are as follows:

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. The main disadvantages of commercial mortgages are as follows:

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 with commercial mortgages

There are a number of other points that you should consider before choosing a commercial mortgage:

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

Why should I purchase property instead of letting?

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.

Disadvantage 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.

What is the usual length of a mortgage?

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.

How much cash do I need to provide for a down payment?

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.

How should the mortgage be structured?

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.

How can I improve my chances of getting a mortgage?

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.

Who is responsible for the repayment of the mortgage?

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 your have formed a partnership, all of the partners involved are jointly and individually responsible. If you a legal company, the Directors may be liable if the mortgage is not repaid.

How can I get a free commercial mortgage quote?

To get your free mortgage quotes, you just need to enter some basic information into our simple online quote form and your dedicated adviser will search the entire commercial mortgage marketplace to find you the best deals available for your business requirements.

Or, if you prefer, you can call a fully trained adviser on 0800 169 4984. It will only take a few minutes of your time today but could save you thousands of pounds in interest payments, and will eliminate any worries you may have about getting the best deal possible.