I am about to enter escrow on a 6100 sqare foot commercial property. The price is $450,000, and the property is leased for $3300/month. There are two offices which are vacant which can be leased for an additional $500-$600/month.

My credit is excellent, and I own a primary residence with a large amount of equity (much larger than the cost of the new property). I have always done traditional mortgages in the past, and have never bought a commercial property.

Would it be advantageous to get a home equity loan to finance the new property? What would be the other options I should look at? Are there variations on the home equity loans I should be aware of? I plan on keeping this new property long term.

Thanks, Mark

Mark:

The good news is that you have put yourself in a strong financial position so that several options are available to you to finance the purchase. While I can not give you the answer as to which of the two options that you presented is the best. I can bounce back some of the things that come to mind regarding the transaction.

What should be the main items to consider regarding the ultimate choice of financing?

In my humble opinion:

1 The primary consideration must be cost. Which of the two offers the best pricing. You mention that your holding period will be long-term. To me this translates into at least 15 years. This would simplify things a bit when it comes to comparing costs.

2 The next important factor is tax considerations. Considering that I am not a tax advisor and that my advice is worth about how much you are paying for it, I would definitely consider the tax implications of a home equity loan against that of a regular commercial real estate loan. You might think that the clear choice would be to go with the home equity so that you can deduct interest against regular income. However, interest should also be deductible against rental income in a commercial loan. Remember you will have { $4,300 X 12 = $51,600 } of rental income if you achieve full occupancy.

What else should I consider regarding the ultimate choice of financing?

In no particular order:

Amortization A home equity loan is amortized over ten or fifteen years {usually}, A commercial real estate loan is amortized over 20, and you can negotiate for 25. This translates into lower payments and of course better coverage.

Term The home equity loan is a one time negotiation that you won’t have to revisit. The ccmmercial loan will probably have a five-year balloon or it can be negotiated to a seven-year or ten-year balloon. This translates into lower fees.

Fees Home equity loan’s fees are usually paid by the bank, the commercial loan fees are paid by the borrower. Since you would not be securing the home equity with the commercial property, you could theoretically buy it without even an appraisal. { I would not recommend this }.

Maximum amount If your home’s equity is enough, you could borrow all $450M, you will be limited to a percentage of the purchase amount under the commercial loan. This is known as maximum loan to value or ltv. {usually 75% or 80%}

This is not so much financing related as it is profit related By looking at your potential rental income along with the purchase price, it seems to me as if the profit margin is going to be a bit tight. I hope that the big tenant is on a triple net lease, and is responsible for maintenance, utilities, etc. You should work the numbers as it stands right now, the property could not repay all $450,000 borrowed under a home equity loan at market rates amortized over fifteen years. You do so you will have to supplement rental income with another revenue stream {wages?}.


What other options should you look at?

Hmmmm, My mind is drawing a blank…… I guess it would really depend on what other resources you have at your disposal.


Hope this helps.

Hi, Thanks for your assistance. I am still in escrow on the commercial property. The lender I'm working with is suggesting that we do a refi on our existing house to get the money for the new purchase rather than getting a HELOC. We plan on keeping the new property long term and have been offered the following loans: 10/1 ARM @ 5.25% and a 10/1 ARM (interest only) @ 5.25%. The HELOC starts at 4% but is adjustable, and will certainly rise over time. I am leaning towards the first option which includes a principal payment.

We can incorporate the entire purchase price ($450,000) into our new loan, although we do have some money ($100,000) that could be used for a down. Is there any advantage to getting the larger loan, or would we be better off adding some cash? Should we consider the interest only loan and just make additional payments each month?

Since the new commercial property will be immediately paid off, would we be able to use it for collateral for future loans, or is our debt on the existing house the main loan consideration?

Thanks, Mark

Mark:

I missed your follow-up while at work today. Good thing, I decided to check up after dinner. Anyway let me see if I have any input on your questions. Remember that I am not a residential lender, so my opinions are not really the best on this subject.

Is there any advantage to getting the larger loan, or would we be better off adding some cash? The advantage of getting the larger loan is that you will end up with a cushion of $100,000 in your pocket. If you lose your big tenant or the new tenants do not materialize, you might need this reserve to keep current. The advantage of adding some cash is obvious, you will not have to pay $5,250 per annum on the $100,000 if you decide to decrease the loan amount by that much.

Should we consider the interest only loan and just make additional payments each month?
Is there some sort of pre-payment penalty on the interest only loan? I guess it comes down to an issue of control. If you can add the principal amount every month on your own, I would say that the interest only makes more sense.

What are the full terms of each option?

Is option 1 amortized over 20 years? 30 years? How about option #2, is it the same length as option #1? If option #2 is the same length then you will have to amortize the $500,000 over a shorter period. Take that into consideration as it will affect your cash-flow in ten years.

Since the new commercial property will be immediately paid off, would we be able to use it for collateral for future loans, or is our debt on the existing house the main loan consideration? Yes, you can use the now free and clear rental property as the cornerstone to build a real estate empire If for example the debt coverage used for the refinancing of your residence is based solely on your regular income. A case can be made that the operating cash flow from the rental property is available to support another facility.

some closing observations:

a- I try to stay away from variable rates, but at least this refinancing lets you lock them for ten years.
b- What is the pricing on your current mortgage? Is the balance significant? Remember that your whole loan amount will be subject to the new 5.25% rate.
c- I encourage you again to go over what I said in the earlier post about how profitable the property is.

Good luck, it seems like you are going about this correctly.