Why Real Estate Might Not Be Your Best Asset for a Business Loan

Trying to secure a small business real estate loan? If so, taking inventory of your assets is a vital part of the process. Personal finances, debts, income, and expenses will all be considered, but what about your property?

Prior to the housing crisis in America, asset-based loans using real estate as collateral (including a primary residence) were a popular option, but things have changed. Lenders no longer look at real estate more favorably than other collateral. Capital gains in personal and commercial properties aren t as dependable as they once were. In fact, owning property can be a significant roadblock for small businesses trying to secure funding because it often causes more financial hardship by putting their assets at risk. In this article, we ll look at why asset-based real estate loans might not be your best option.

Understanding asset-based real estate loans

Before we get into why real estate might not be your best asset (and considering other lending streams), you first need to understand how a lender views your assets.

Asset-based lenders look to secure their commercial loans using tangible or non-tangible assets owned by the applicant. These might include your house, business premises, land, or even other asset classes like stock market equities or mutual funds.

These assets aren t just proof of your financial health; you re essentially putting your investments, savings, and even your home on the line to get capital for your business now. This is often referred to as a secured loan.

What about mortgages?

Lenders who are willing to make asset-based loans using personal real estate know that the borrower most likely already has a mortgage on their property. Many lenders have been willing in the past to take second positions subordinate to the mortgage lender and still provide financing.

However, the caveat is that a great deal of equity needs to be built into the home for that to happen. Equity is calculated by taking the value of your property and subtracting any mortgages on the property. Any other potential liabilities are also subtracted, such as any liens you might have on the property. If there s still a positive sum, there is equity in your property.

What is collateral in real estate loans?

If you opt for an asset-based real estate loan, whether purchasing inventory, expanding your business, or some other business purpose, any property in your investment portfolio that you or your business own and have equity in can be used as collateral. Real estate essentially provides lenders with the additional security they need. But remember, any ownership you have in your property will be in jeopardy if you default on the loan.

Often, real estate asset-based loans are used by businesses with poor credit or no other capital. Funding can sometimes be approved for up to 90% of the property s value. Unlike more traditional real estate loans, the money can be used for a variety of business needs or to smooth over any short-term cash flow issues.

When to use an asset-based real estate loan for your small business

There are some instances where it might make sense to get an asset-based real estate loan as a way to fund an initiative for your small business, whether to buy real estate, expand, or even cover short-term operational costs.

Example #1

Let s say you own a $350,000 home. Your remaining mortgage is $250,000, which is subtracted from the $350,000, leaving $100,000. You have no other liabilities against your home, so you have $100,000 in equity. You re trying to get a commercial real estate loan for a multi-family investment property that you want to rent out to gain passive income. But the asking price is $50,000 over its appraisal. The property is in a prime location, and you feel it s a great investment your ROI will be huge. Even your real estate agent agrees. So, you re willing to put your personal real estate property as collateral to get it. Your lender might find this attractive.

Example #2

You want to expand your company by purchasing a competitor s business. But you lack a down payment for purchasing it and want to offer something else in exchange for getting your loan approved. Using the equity in your home as collateral could help you do it. The only question is, will a lender be willing to place a second mortgage on your home? If you have enough equity!

Example #3

You want to refinance your current small business loan, so you have more manageable monthly payments. But the value for your commercial real estate property has gone down. You also don t want to dip into your working capital for closing costs or other real estate transaction costs. You decide you want to use your primary residence as collateral for the loan. This could help you achieve your goal of lower monthly payments.

So, is using real estate property a good idea?

It probably depends in large part on where your property is located. There have been many economic downturns in the past several years. Property values have swung wildly over the past decade.

For example, single-family home prices in Miami averaged $106,000 in 2013. Today, American homebuyers pay an average of $436,000. California is another area where real estate tends to continuously go up in value rather than down. But where real estate prices might grow in value, depreciation is always a concern in the real estate housing market for homeowners and small business owners alike.

So, for many lenders to approve an equity-based real estate loan, they might prefer a property that has more than $100,000 in equity depending on the volatility of the real estate market where the property is located.

In some cases, it might make more sense to get revenue-based financing that won t put your property at any extra risk.

Other reasons businesses borrow with real estate equity

Small businesses often use personal or commercial real estate as the basis to obtain a loan, either because they have less-than-perfect credit or because they have equity in their land or building.

One example might be rental property. Let s say you own a multi-family apartment complex, retail strip, or other rental property. Suppose a law has changed the code and requires you to invest more to bring your property up to code and protect your real estate investment. Or perhaps upkeep and maintenance costs have increased and eaten into your cash flow.

Or maybe you own a retail strip mall that has seen fewer renters and higher vacancies that have reduced your rental income together. So now you want to do renovations to attract new tenants. Most small business owners don t have a lot of money lying around.

In any case, you might consider an asset-based real estate loan that puts your home or business premises as a guarantee that you will pay back the loan in full and on time.

Why real estate might not be your best asset

There are many reasons why real estate may not be your best asset. Thankfully, there are several different alternatives. Before we look at other options, these are the reasons you may reconsider securing a loan against your property:

Real estate is an illiquid asset.

During a typical loan application, a lender will look for evidence of liquid assets. Liquid assets are assets that are either cash or can quickly be converted into funds to cover you if you lose your primary income source. You re more likely to be accepted for a loan and get a better commercial loan rate if you have liquid assets to fall back on, as there is less chance you ll default on your payments.

Illiquid or fixed assets, on the other hand, take longer to convert into cash, and their value may change in the process. Real estate is illiquid because the value of a property is always changing, plus the sale process takes a long time and is dependent on other factors.

Real estate can become collateral.

By offering real estate as security, you re giving the lender a legal claim to your property should you default on your payments. This means that if you don t stick to the repayment plan, your property could be repossessed or sold instead of being paid for.

Asset-based real estate loans cost more than traditional loans.

Despite the advantages of asset-based loans, they can also be expensive. Interest rates vary, and banks will sometimes add audit and due diligence fees to the overall cost of an asset-based loan. Larger banks might also require a personal guarantee as well as confirmation of any other banking relationships.

A third party could end up managing your cash flow.

In most cases, asset-based lenders will require that your customers send payments directly to the finance company, which means a third party gains control of your company s cash flow. The lender, for example, might reserve more cash from customers instead of turning it over if receivables lengthen.

Alternatives to home equity financing

There are many alternatives to home equity financing, including:

• Unsecured small business loans: You can find government-backed unsecured small business loans for up to $500,000 by searching online.
• SBA loans: The US Small Business Administration is designed to provide financing for the purchase of fixed assets, which usually means real estate, buildings, and machinery, but at below-market rates. These are referred to as SBA loans.
• Business loans for women: There is an increasing number of small business loans for female entrepreneurs. In addition, there are women-only business grants, mentorship programs, and other resources that can provide revenue for your business.
• Business line of credit: A line of credit will give you access to a specific amount of money, but you don t need to use all of it. In this instance, you only pay interest on the funds you draw out. Once you ve paid back what you borrowed, your credit line goes back up to its original amount.
• Term loans: Both traditional lenders and alternative loan providers offer term loans. These can be used to expand your business, free up cash flow, invest in real estate, or for a wide variety of reasons.
• Revenue-based financing: This type of funding uses a percentage of your receipts in exchange for funding. It puts less strain on your working capital and differs from equity financing as it doesn t put your assets at risk.

Conclusion

Secured loans are less risky for lenders, but they are incredibly risky to the borrower. Defaulting on an asset-based real estate loan means your lender could reclaim the outstanding debt from your property or force you to sell.

To borrow home equity effectively, you need stable interest rates and rising home values. In other words, this strategy works best in a strong economy, but you also need to shop around if you want to find the best rates. Even if you re operating in a healthy economic environment, many financial planners will warn you not to borrow from home equity for any or all the reasons mentioned above.

Thankfully, there are other lending streams such as small business loans and unsecured loans that could provide the cash injection your business needs without putting your property on the line.

FAQs

What is the best small business loan option?

It depends. If you need money quickly for extra working capital or to leverage a business opportunity that won t last long, revenue-based financing may be the best option. On the other hand, if you re looking to invest significantly in real estate, a commercial real estate loan on its own or one that incorporates other solutions may work best.

Is credit score a factor in real estate loans?

Yes. Credit score will be a factor in almost any loan you seek. Even with alternative lenders who allow for much lower credit scores than banks, your credit score will impact how much interest you pay and the terms of your loan.

What is the average downpayment needed for a commercial real estate or small business loan?

It depends on the type of loan and the lender, but typically, downpayments range from 10%-30%. However, a few lenders and some types of loans don t require a downpayment.

How much can I borrow in a small business or commercial real estate loan?

It depends on what the loan funds are used for and the type of lender you use. For example, the SBA will loan up to $5 million through its various financing solutions, while for commercial real estate loans, you may be able to get financing for a Loan-to-Value (LTV) ratio of 75%-80%.

Revenue-based loans are based on your business receipts, and the average loan amount is just under $100,000.

What type of credit score do I need for a commercial real estate loan?

Again, it depends on the lender and many factors. Many lenders offering commercial real estate financing look for a score of at least 650, but they will also factor in things like your business plan and the LTV ratio you are seeking.

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