The commercial real estate industry is facing economic challenges as the Federal Reserve raises interest rates to control stubbornly high inflation. The mood among real estate finance professionals is, at best, cautious optimism. To deal with this sense of uncertainty, mortgage brokers may want to look at expanding their menu of loan services.
Commercial mortgage brokers are expected to have the experience, skill and knowledge to assist in arranging almost any type of business-purpose funding requested by a potential client, including financing the sale of a privately held business. A privately held business is a company that is not publicly traded, which means that the company did not raise capital through the sale of stock via public offering. Privately owned companies include family-owned businesses, sole proprietorships and many other firms of all sizes.
It is essential to remember that most businesses have some level of investment in real estate either through leasehold or fee-simple agreements. The degree of real estate holdings will have a major impact on a company’s valuation and subsequent loan requirements.
“The idea of owning a small business is a common dream for many people with entrepreneurial spirit. But there are many financial issues associated with the acquisition of an existing business.”
One potentially attractive area for mortgage brokers to explore is change-of-ownership loans to small businesses. There are approximately 32.5 million small businesses in the U.S., which represent more than 99% of the nation’s businesses, according to the U.S. Small Business Administration.
The idea of owning a small business is a common dream for many people with entrepreneurial spirit. But there are many financial issues associated with the acquisition of an existing business. Commercial mortgage brokers interested in expanding into these types of transactions should start by developing relationships with business brokers or merger-and-acquisition intermediaries.
These connections will help generate a regular source of new lending opportunities. In many cases, the business owner will require the professional services of a business broker in preparing the business for sale, determining a realistic sales price, marketing the sale and negotiating with potential buyers.
In addition, sales will often require lender financing. This is where the commercial mortgage broker enters the picture. They can place the loan with a lender that understands the intricacies of change-of-ownership deals and has the appetite to fund these types of transactions.
To begin the acquisition process, the prospective buyer and the mortgage broker must conduct due diligence. This includes inquiries as to what services or products the subject business offers, how long the company has been operating and its reputation in the local business community.
A thorough review of the company’s financial statements is necessary to confirm its ability to meet future obligations, including debt service. In addition, the lender must evaluate the probability of maintaining and expanding the level of future earnings, which is the primary source of repayment.
Other areas to investigate include supply chain and staffing issues. For example, a manufacturing firm could be dependent on a specific type of synthetic ingredient that may not always be available. Alternatively, what if it became necessary to transport the synthetic product from a source hundreds of miles away? The potential cost increases would decrease future profits.
Labor is also a foremost area of concern. Are workers voting to unionize in the immediate future? Are key employees willing to stay on with the new owners? These issues affect the sales price and the size of the loan.
Corporate financial statements are crucial elements to helping the parties arrive at a logical sales price. The commercial mortgage broker should realize that the final price may account for items known as “blue sky” or “goodwill.” These terms encompass the business’s reputation, its brand recognition, customer and supplier lists, and other factors. The value of goodwill can be calculated, but it doesn’t have collateral value.
Brokers must pay attention to customer relationships. What is the company’s reputation with its existing and potential customers? Is the principal customer related to the present owner? If customer problems exist, posting an “under new management” sign will be inadequate.
Equally important is what creditors (trade suppliers, current bank, etc.) think of the company and its future. The big question here is whether they will continue to extend credit in the future. Again, these issues will affect the sales price and the loan amount.
Seek professional help
When purchasing a company, a buyer may acquire either its assets (consisting of the receivables, inventories, equipment and real estate) or corporate stock. The mortgage broker should thoroughly understand these issues because the method used will likely affect the buyer’s and seller’s tax liability, and thus may impact the purchase price.
The tax implications of buying or selling a business are extremely technical and constantly changing. It is advisable that all parties involved secure professional tax counsel.
If the buyer decides to purchase the assets of a company, both parties may wish to secure legal counsel, which will draft a sales contract that identifies the specific assets being sold and the amount paid for each item. This agreement will provide a foundation for depreciation and potentially the total tax liability. These details also impact the sales price and loan amount.
Additionally, legal counsel may be able to help the buyer avoid any potentially unknown liabilities of the business, including latent legal actions. Finally, the buyer may choose to enter into a noncompete agreement with the seller, in which the buyer pays the seller an additional dollar amount to not open a similar business in the respective trade area.
Drivers of value
Mortgage brokers should keep a wide variety of factors in mind when analyzing the drivers of a property’s value. These include the business location, its historical growth and profitability, the current owner’s reason for selling, the quality of their financial statements, the projected future profitability, the existing client base, any barriers to entry and any regulatory burden. Other factors include competition, the future of the subject industry and the future of the company’s products. Also look at the company’s technology tools and any possible environmental concerns.
Once due diligence and negotiations are complete, and the sale price is determined, the next step for the broker and buyer is to develop a plan to finance the transaction. The following list describes just some of the documentation that brokers will need to adequately prepare the loan request package:
- A detailed description of the subject business
- A signed copy of the sales agreement
- A detailed list of assets that will serve as loan collateral, including estimates of each item’s current value
- A copy of the real estate purchase contract, if real property is involved
- The complete business plan that states the company’s objective and how its goals will be accomplished
- The entity’s balance sheets and income statements for the past three years
- The amount of equity the new owner intends to invest in the business
During the application process, the lender will evaluate and determine the collateral value of the assets involved in the acquisition, which offer security for the loan. In some cases, the aggregate value of the collateral may be less than the requested loan amount.
This does not mean the deal will be turned down. There are several alternatives to be considered, including having the lender make a loan with less than 100% collateral, or having the borrower offer additional collateral, such as a second lien on their home.
Alternatively, the lender may suggest the seller take a carryback on a portion of the sales price and accept a second-lien position behind the lender. If cash flow is an issue, the seller may be willing to defer some or all their payment until such time that the company can support the additional debt.
Repayment terms are issues that must meet everyone’s needs. Again, depending on the lending institution’s policies and liquidity needs, the terms generally can and should be structured to meet the borrower’s cash flow needs as well as the economic life of the collateral.
Seven to 10 years may be a reasonable timeline for equipment financing, while shorter terms are common if working capital is part of the loan proceeds. If commercial real estate is the primary collateral, 20 to 25 years is common. If all types of collateral are included, as is frequently the case, a blended term may be appropriate.
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Commercial mortgage brokers should remember that change-of-ownership financing may not be easy for the buyer to obtain. Therefore, the broker should emphasize the opportunity to cross-sell many other services. This will help to establish a long-lasting, profitable and mutually beneficial relationship with a new entrepreneur, the engineer of the train that runs the economy. ●