How SMEs Can Use Property Loans to Lower Their Borrowing Costs

By Paul Ho (guest contributor)

Singapore’s SMEs makes up 99% of all enterprises, employ 66% of the workforce and account for 48% of the GDP. SMEs are defined as having revenues of less than $100m and with a staff of less than 200.

Singapore has narrowly averted a technical recession. But the PMI is below 50%, indicating a contraction in the manufacturing sector.

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Figure 1: Purchasing Manager’s Index (PMI), Singapore Institute of Purchasing and Materials Management (SIPMM)

SMEs have limited access to loans during tough times

A drop off in demand means that companies are hardly growing their top lines and may go into the red. This is especially true for SMEs with less than $10m in revenues.

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Figure 2: Singapore Quarterly GDP Growth rate (TradingEconomics, SingStats)

Singapore’s corporate default rate of Corporations listed on the SGX is below 2%. SMEs likely have a higher default rate of at least 3 to 4%.
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Figure 3: Corporate NPL Ratio, Financial Stability Review 2014, MAS

During the Global Financial Crisis in 2008, Singapore’s SMEs experienced a limited access to capital and funding. This led the government to enhance the various schemes that are in place to help SMEs retain access to credit. Most of these schemes involve the government risk-sharing with the banks on loans to SMEs.

In short, this means that during tough times the banks cut back on SME lending exposure due to the potentially higher Non-Performing Loan risks. Hence funds will likely dry up during uncertain economic periods when SMEs need credit the most. Hence SMEs will be exposed to elevated funding disruption risks and increased cost of funding during recessionary periods, and need to take action now to secure funding.

Discerning future interest rate trends by looking at the bond yield curve

The bond yield curve gradient has become less steep, indicating slower growth. There is also higher mid and long term interest rate expectations, indicating inflation expectations or simply a higher interest rate environment. The 20 year Bond is currently at 2.9%.

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Figure 4: Singapore Bond Yield Curve End 2014 versus Nov 2015, Asian Development Bank

Hierarchy of Borrowing Costs: Secured versus Unsecured Loans

The impending weakness in the economy poses greater risks to SMEs than to large corporations

Secured lending refers to lending in which an asset is pledged. Secured lending presents less risk to the lender and hence they charge lower interest rates.

Unsecured lending does not require pledged assets. Hence this presents greater risk to lenders and are more expensive. Small businesses usually have fewer assets to collateralize against and hence use secure loans less frequently. Unsecured Business Term Loan rates for SMEs are usually in the 10+% range, depending on loan size as well as tenure.

The Micro Loan Program by Spring Singapore is also a good source of funding. However, not many companies qualify, and for those who qualify, they may not be able to obtain the maximum $100,000 loan. Interest costs start from 5.5% with up to a four year tenure.

Problems faced by SMEs and their owners in obtaining credit

Many SMEs may not have the right financing or salary structure. SME bosses tend to under-declare their income and instead declare dividends. Whilst this reduces their taxable income, with the new Total Debt Servicing Ratio (TDSR) rule, this also impedes many SME bosses from borrowing more to buy their homes.

SMEs are suffering a margin squeeze. Faced with borrowing costs of around 10%, labour costs that are 5 to 10% of revenue, and other operating costs which could take up another 5 to 15% of revenue, these businesses need a gross margin in excess of 30% just to break even. Not many industries can offer gross margins in excess of 30%. Hence SMEs are especially sensitive to top line growth for those with 20+ to 40% gross margins.

With market uncertainty, access to funds for SMEs could be even more restricted in the coming one to two years.

How can SMEs overcome high cost of funding issues?

SME bosses should start to realize that under-declaration of income impedes borrowing and start to rectify this situation to reflect their true income. While it is important to have a tax efficient salary structure using a combination of Salary, Director Fees and Dividends, it is worthwhile to review this to be eligible for adequate funding.

SMEs, especially those whose directors who are currently in their late 30s and early 40s and who have bought their own residential homes, could be sitting on tied up equity in their properties. Residential home loan rates are around 2%. They could free up this capital by refinancing their homes and use the money to invest prudently in their own business. With this reduced cost of funding, the business owners could immediately save ~10% off borrowing costs.

Case Study: SME owned by 2 Directors and 3 Shareholders

Does it make sense to borrow against your home for a company in which you’re only one of the many directors?

In this case I came across, the company had two directors and three shareholders. The two Directors owned 35% each of the business, while the rest of the shareholders held 10% each.

They needed $500,000 of funds for business expansion.

We advised the firm to structure a Director’s resolution to approve the company to request for a Shareholder Loan to the company at a 5% interest rate. The two major shareholders cum Directors held 70% of the shares, and hence were allotted $350,000 of the loan amount. Shareholders or Directors who did not wish to lend to the company at the approved 5% interest rate may give up their allotment. The unused allotment may be used by the other directors/shareholders equally.

These two major shareholders then refinanced their residential property loan with a cash out (equity term loan) of $400,000 at 1.8% interest. They then lent their company $400,000 at a 5% interest, making a decent return on their loan to their own company. Another two shareholders took up their allotment and lent the company $100,000 at the same 5% interest.

In this way, the company had access to cheaper capital, boosting its chances of survival and creating a fair debt offering for all directors and/or shareholders who wanted to participate. It’s similar to preferential bonds which only Directors and shareholders can participate in.

SUMMARY

SME owners should get their personal income structure right to optimize for both tax efficiency and borrowing capacity. They can then leverage on cheaper secured mortgages to free up equity from their house to lower their business borrowing costs by structuring a Director’s Loan to company.

In order to lock in low rates from the residential property equity loan (cash out), it might be safer for SME owners to consider a three to five year fixed rate structure to hedge against rising interest rates.

Investors with at least $300,000 of spare cash could also get in on the game to bridge the gap left behind by banks and lend to growing companies who can afford to pay 14 to 18% per annum in interest costs. But thorough risk assessment needs to be done to minimize default rates. Convertible loans can also be structured to give investors additional upside if there is a liquidity event (e.g. acquisition).

By Paul Ho, holder of an MBA from a reputable university and editor of www.iCompareLoan.com, Singapore’s first Cloud-based Home Loan reporting platform used by Property agents, financial advisors as well as Mortgage brokers.

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