Business Finance Explained

A mortgage is probably one of the best understood financial products. After all, many of us have mortgages to buy our homes. So it is with commercial mortgages, which are taken out by the owners of a business to buy the warehouse, factory or office premises from where their firm operates; or to re-mortgage an existing loan on more favourable terms.
They can also be taken as an investment on a ‘buy-to-let’ basis, where borrowers rent the building they’ve purchased out to a business (although in this case the lender may restrict the type of tenants you can have). However, they differ from residential mortgages in that they can also be used for other things.
For example, you can use commercial mortgages to buy a going concern (which might well include a property) such as a farm, pub, restaurant or care home. They can be used to part fund a management buyout or corporate acquisition, or even to simply raise some additional working capital to help take your business forward.

Advantages

Commercial mortgages are often the best way to finance the purchase of land and/or buildings for your business. Instead of raising funds by selling an interest in your business to an investor who will expect a percentage of your company and its profits in return, you’ll retain 100 per cent ownership of your business and acquire what is potentially an appreciating asset.
Although obviously lenders are entitled to interest on the loan, provided you don’t default, they cannot take a stake in your business. Repayments on a mortgage are likely to be similar to rental payments. By buying instead of renting, especially if you opt for fixed rate loan (see below), you’ll be protected against any hefty rent rises and you’ll be able to sub-let any free space that you might have (although you will almost certainly require permission from your lender to do so).
You will also have the opportunity to build extensions and make conversions to your premises.Your cash flow should improve as a mortgage gives you immediate access to funds with relatively low set-up costs and you can use that cash for other, more pressing, needs. As mortgage repayment schedules are agreed in advance, and can also sometimes be flexible, it should be easier to manage your budget. Interest payments on commercial mortgages, like other loans solely for business use, are also tax deductible.

Disadvantages

Unfortunately, there are also drawbacks. Unlike renting, you'll need to come up with a substantial deposit. Typically you can borrow up to around 75 per cent of the property’s value, although you may find a lender prepared to lend more subject to a higher interest rate or increased security.
If you plan to rent out the property, lenders will look at the projected rental income to assess the maximum loan-to-value. A typical ratio is 130 per cent, meaning the annual rental return should be 130 per cent of the commercial mortgage payments.
If you own premises but with a mortgage, this means that you are much more tied down than if you are renting the premises. This can be important if you think you may need to relocate. Clearly, it is likely to be less hassle to end a rental agreement than to have to sell your premises, or find a tenant to rent them from you, so that you can move elsewhere.
Although you won’t face hikes in rent that are outside your control, you will be exposed to increases in interest rates, a pertinent factor in today’s economic climate. Being a property owner also carries with it certain responsibilities, such as maintenance, fixtures and fittings, insurance and security.

Interest Rates

The pricing of commercial mortgages is more complicated than in the residential market, and there are a number of different criteria used by lenders for setting the interest rate you’ll pay.
The rate will depend on many factors, not just current interest rates. For example, your own credit history (and that of any tenant, if you are letting the property), the past and projected performance of your business, the security you can offer, and general conditions within your particular industry sector will all be taken into account.
You will probably still have the option of either a fixed or variable rate. With a fixed rate, the interest rate will be fixed for a predetermined period that may or may not equal the length of your mortgage. Obviously, the advantage of a fixed rate loan is that you’ll know exactly what your repayments will be for the duration of the fixed period. However, if rates fall, you’ll lose out. At the end of the fixed rate period you can generally revert to the standard variable rate or negotiate another fixed rate for a set number of years.
Variable interest rates are more common and generally link your repayments to either bank base rate or Libor (the wholesale money market rate). Commercial mortgages tend to be between 1.75 per cent and 3 per cent over base rate.
You might also be able to borrow at a ‘capped rate’ meaning the variable rate cannot rise above a pre-determined limit for an agreed period (usually no more than 5 years), after which it reverts to the standard variable, or a ‘cap and collar’ rate, which has both a ‘ceiling’ and a minimum rate that interest cannot fall below.
Generally speaking, you can initially get a lower interest rate on variable interest rate mortgage than on a fixed rate mortgage.

Liability

Liability for repayment of the loan depends on the legal structure of your business. If you are a sole trader you will be personally liable for the mortgage debt, and you should be aware that your personal assets may be seized if the business defaults. If you are in a partnership, then you and your partners are jointly and severally liable for any debts the partnership incurs, and again your personal assets are potentially at risk.
With a limited-liability partnership and a limited company, where liability falls firstly on the business, rather than on the individual partners and directors, a lender may take a floating charge on business assets in general, rather than simply on the current property being purchased. The lender may also insist on personal guarantees as a condition of granting the loan, in which case the partners and directors can still be held personally liable.

Things to look out for

You’ll probably have to pay an arrangement fee, typically between 0.75 per cent and 1.25 per cent. Legal costs will also be higher as commercial property transactions tend to be more complex than residential ones and there may be a completion fee as well. Beware of early repayment penalties. If your new business venture is a rip-roaring success and you want to retire after a couple of years, you don’t want to have to pay an early redemption fee before heading off into the sunset.
At the other end of the spectrum, should you experience difficulties, it’s may be a good idea to negotiate a ‘grace’ period, for example if your monthly payment is due on the first day of each month, ask your lender to allow you until, say, 7th before the payment is deemed to be late.