Leverage construction loans for AEC business real estate ownership, enhancing assets and financial health.
It’s interesting to me how many architects and engineers who own their own businesses and serve developer clients don’t understand how they themselves could benefit from commercial real estate ownership – either through their business, or with a separate entity outside the business that leases space to the business.
Most think they can’t afford it. They are already undercapitalized. How could they buy a building when that typically would take a 20-25 percent down payment, plus require them to do all of their own buildout, when they can probably get their landlord to finance a lot of that to them through a long-term lease with higher rent.
The answer is to do what your landlord does!
Whether you want to do an all new greenfields build, or buy an existing building and renovate it to meet your needs, the process and vehicle you can use to finance it is pretty much the same. Use a construction loan!
Here’s how that works. Let’s say you want to build a new 40,000-square-foot office building for your firm. You will plan on using 25,000 square feet for yourselves and lease out the other 15,000 square feet so you have some space for future growth. So you find an available site, design your building, and then go to the bank to get a construction loan to build it. Depending on your company’s or your own financial wherewithal, you can probably borrow about 80 percent of the completed value of the building in a construction loan. A construction loan is a one-way line of credit. It goes up but doesn’t get paid off until you are finished with the project and convert to an amortizing loan.
So in my example, let’s say that your construction cost estimate for this building, designed and built out to your spec, is $9 million. You can get it down that low because you are not only designing it, but you also plan on being the GC on the project. You also have to buy the site for $1.7 million. So you need $10.7 million to do the project.
You have to get a loan, and you want it to be as large as possible so you put the least amount of cash into this thing. How will you do that? You have to get the best post-construction appraisal you can get. Commercial real estate appraisers use projected income to set the value. They also use what is called the “cap rate.” So today, let’s say you are in a market where a 6 percent cap rate is the norm for office space. You can find that out by talking with local commercial real estate agents.
Cap rate is basically determined by the risk associated with investing in that type of income-generating property in that specific geographic area. The lower the risk assessment, the lower the cap rate. The lower the cap rate, the higher the value. So, for example, an office building in Newport Beach, California, would have a lower cap rate than the same type and size of building in Muskogee, Oklahoma. Newport Beach could be a 3.5 or 4, and Muskogee could be a 10 or 12. That greatly impacts the value.
Here’s how it works. You add up all of the rents (or projected rents) the building will bring in over the year, and then deduct property taxes, insurance, utilities on common areas, and maintenance, along with some reserve for less than full occupancy in a multi-tenant facility. A good rule of thumb that my experience tells me most lenders will go for is to use about 85 percent of annual rent payments. Then divide that by the cap rate, and voila! That is the value for the completed project.
So let’s take our 40,000-square-foot office example. If, in your area, the going rate for nice office space is $25 per square foot annual rent, that means your total annual rent income (coming from your own business and from your tenant space) will be projected to be $1 million a year. Multiply $1 million by .85 and you get $850K. $850K divided by .06 (the cap rate in this example) gives you a value of $14,166,666.
Your estimate to build the project was $10.7 million. But you will be able to borrow 80 percent of $14.67 million, or $11.74 million in your construction loan. That gives you $1 million more than you thought it would cost to do the project for contingencies. So you get your construction loan – typically interest-only for two years or so, buy the site, build the project for $11.74 million or less, and at the end, when it’s all done, you convert your construction loan into permanent financing.
The original appraiser will be called in to do the final appraisal, and as long as you built what you said you would build, they will typically set the value at what they projected it would be worth. So instantly, you now have a $14.67 million dollar building with nearly $3 million in equity in it. As long as you can lease out the other space, you did it all with no cash out of pocket other than interest during construction, and some banks will even let you use your construction loan to help pay for that.
You can do the exact same thing with the renovation of an existing building. Obviously, the worse condition it is in, the better, because there is more of an increase in value through your improvements and that gives you a better shot at doing it with little to no out of pocket cash. And if your rent payments aren’t enough to cover your loan, just bump up your lease from the AEC firm a little bit. Rates do go up and down and should be coming down by at least 1 percent in the coming year; you may have to bet on that.
Twenty years from now, hopefully your building is worth two or three times what you paid for it. You have also paid the loan down entirely or in large part. Now you have a significant asset, owned either by your AEC firm, or by some or all of the partners in the business. Consult your tax advisors for what they think is best. It’s a classic small business wealth-building story!
Mark Zweig is Zweig Group’s chairman and founder. Contact him at mzweig@zweiggroup.com.