The nuts and bolts of commercial loans

This article was first published in Australian Property Investor Magazine and is copyright and reproduced with their permission.

Financing a non-residential property venture is all about the numbers.

When it comes to financing an investment property, there are manifest differences between commercial and residential loans.

ANZ’s managing director of business banking, James Flintoff, explains, “Residential land is generally used for residential or investment purposes, while commercial property is used by businesses as their operations base or as an investment.”

As such financing a commercial investment endeavour is not as emotive as residential. Commercial finance is all about the numbers, what the investor hopes to achieve and the actual business behind the venture. The occupants of a residential investment won’t impact on your financial obligations to the lender but commercial tenants can make or break a non-residential loan application.

Metfund director Craig Coverdale says, “These investments generally offer better quality cash flow and higher yields than residential property and it’s the cash flow of a transaction that’s really important for commercial investments. That’s what lenders focus on.”

Another disparity between residential and non-residential lending involves loan terms.

“Generally, the maximum commercial property loan term we offer is 15 years,” Flintoff says. Shorter finance periods are standard with commercial property for a number of reasons.

“Five years is a very common loan term for commercial property because it recognises that these are active investors,” Coverdale explains, adding that in his experience the average life of a commercial loan is around three and a quarter years. By that time, loans are usually refinanced to allow for new properties to be added or development and expansion.

Perusing the products
Loan products for commercial investors are almost as varied as for residential and are specifically tailored to suit the needs of the individual and the desired outcome of their venture.

ANZ offers a “Business Loan”, for example, that can be secured by commercial property or other assets or unsecured.

Flintoff says, “Repayments can be structured to the cash flow of the business; (they) can be interest only and either fixed or variable. Ultimately, it’s a matter of choosing the right loan to suit investors’ individual circumstances.”

Coverdale says the vast majority of commercial loans are interest only because commercial property investment is all about maximising cash flow.

“You’re not living in the property – it’s a pure investment,” he says. “So it needs to stack up against the equity market, fixed interest or any other opportunities. By going interest only you minimise your interest expenses and maximise the cash return.”

All about the bottom line
The cash flow a commercial property produces comes into play in a big way when you start talking finance.

Coverdale says, “A residential property is probably going to yield somewhere between 3.5 to 4 per cent tops whereas with a commercial property you’d be looking for a yield somewhere between 6.25 and 7.5 per cent in the current market, depending on the asset type and location. At a reasonable LVR (loan to value ratio) those income levels will deliver a cash surplus to you month on month.”

He argues that there’s a very tight relationship between the equity amount a commercial investor outlays and their ultimate goal to gain a decent cash flow return on the property.

“You’re looking for a surplus of cash on a consistent basis. On a reasonable LVR at current interest rates of about 7.8 to 7.9 per cent if you were to gear a property up to between 70 to 75 per cent with a rental yield of around 6.5 to 7 per cent, that property should just be making some returns back to the investor in a cash flow sense. That’s why if you increase your LVR to 80 or 85 per cent and you’re paying a margin of 2.25 per cent on your loan, the property will become negatively geared and the numbers won’t stack up.”

Getting the loan amount and LVR right from the beginning is imperative. So too is meticulously researching the asset selection to ensure the strength and longevity of the commercial property and the investor’s ability to meet their financial obligations.

“Essentially what we’re talking about is marrying the potential income of the property and the income of the borrower,” says Coverdale. “You have to have certainty about how much the rental stream will be and if the borrower or tenant falls over you need to know that the rental stream can be re-established quickly.”

For this reason the location of a commercial property investment is critical.

“If a tenant in a retail shop in a prime location fell over you’d rent it out again in a week, whereas in a small rural town the property could be sitting vacant for three to six months. So the credit decision is reliant on the strength of the property as well as the borrowers and based on the asset you can then establish what type of deal can be done.”

Interest varies
The LVR can also affect the interest rate margins you’ll end up paying. Mortgage insurance is not an option for commercial investment loans as there is a definitive maximum amount a lender will approve. This ensures the borrower will see the necessary returns on their property to make the venture worthwhile.

Flintoff says ANZ will look at financing up to 75 per cent for business loans, however if a customer can demonstrate a capacity to service a higher LVR, they can extend this limit somewhat. He qualifies that the interest rate payable on such loans will vary according to the level of security.

Increased competition has altered the landscape of commercial property lending in recent times with numerous super funds receiving billions of dollars of fresh cash that’s finding its way into the commercial lending market.

Coverdale says, “That increased liquidity is being reflected in commercial property loan prices and the margin’s being charged. Companies such as ours are now outstripping prices available through the big banks.”

He explains that the rates and pricing for loans are linked closely to the LVR.

“In other words if your LVR is less than 60 per cent then the interest is your 90-day bank bill swap rate plus a margin of between 0.9 and 1.1 per cent. If your LVR is between 60 and 70 per cent the margin is about 1.1 to 1.4 per cent. For 70 to 75 per cent it increases to about 1.4 to 1.65 per cent and above 75 to 80 per cent, which is where you see a lot of the smaller players, the margin’s around 1.65 to 2.25 per cent.

“Most of the bigger players sit in the LVR range of 60 to 70 per cent range or less. They maximise the cash flow yield by minimising interest margin costs.”

In regard to fees, there can be line or undrawn charges with some bank products, however Coverdale suggests that most of the super funds offer fee-free loans with the exception of an establishment fee.

He says that in most instances for smaller players an LVR of 70 to 80 per cent is standard, however deals can be done at an LVR of 85 per cent in some circumstances.

“Deposits of 15 per cent are achievable but with a smaller deposit you have to scrutinise the deal more closely and the numbers regarding both the property and the borrower need to stack up.”

The right qualifications
Essentially commercial lending is based on the merits of the property as well as the borrower and their lending capacity.

“ANZ takes a range of factors into account in assessing an individual’s loan application and deciding how much to lend, including their savings history, credit history, income, living expenses and financial commitments,” Flintoff says.

“As with most commercial loans, an investor will need to provide copies of financials (pay slips, tax returns or accountant-prepared financials), details of other debt and expenses and a satisfactory credit check.”

Coverdale says that apart from dissecting the lease’s stability and longevity and the cash flow potential of the property itself, “we require company tax returns and two years worth of personal tax returns. If you don’t have these the deal’s still doable but there might be a premium paid if you go down the low-doc route so you won’t be making the most out of your interest rate and cash flow surplus.”

Bronwyn Davis is editor of Property Update and contributing editor to a number of top selling property books. As a property & finance journalist she regularly contributes to various industry magazines and has over 20 years experience in property.


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Bronwyn Davis is editor of Property Update and contributing editor to a number of top selling property books. She is also a regular contributor to Australian Property Investor magazine, Australia's top selling property magazine.

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