Commercial property finance is very poorly understood, and this is a major contributor to poor decisions by investors. The most important thing to know about commercial property loans is that there is no hard and fast rules about factors such as the leverage that is available, costs associated with commercial loans or the lending criteria. In commercial finance everything has to be viewed relative to the strength and size of the particular deal.
How are commercial loans different?
Most people are used to residential mortgages, whereby a lender offers a set rate and charges and offers different amounts of leverage depending on the location of the property. Servicing is calculated by taking into account all of the debts and all sources of income attributable to the borrower(s) or guarantor(s). There are commercial lenders who operate using a similar system, but generally these lenders only deal with smaller transactions in restricted geographical locations. The main point here is that residential lenders price most deals that they agree to fund the same way, with possibly some discounting for larger loans, perceived risk is a factor that dictates whether they will fund a loan or not, but has no bearing on price.
Commercial lenders, as a rule, place significantly greater emphasis on quantifying risk and apply different leverages, as per residential loans, depending on the risk they perceive to be inherent in any particular security, but in this case they also adjust pricing according to the same factors. Thus two loans the same size can have significant differences in terms of pricing.
What factors affect risk?
Lenders look at a wide range of characteristics when determining the risk level of a transaction, these include:
- The financial strength of the borrower
- The experience of the borrower in managing the particular style of property
- The experience of the borrower in managing property in that location
- The financial strength of the tenant
- Guarantees attached to the lease
- The term of the lease
- Relevant clauses in the lease such as market reviews
- The current strength of the local market
- Overall economic conditions at the time
- The lenders view of the geographic location of the property
- The lenders view of the particular type of commercial property
- Possible alternate uses for the property
- Whether you plan to hedge against interest rate movements
- The leverage that the borrower is after
How does this affect price?
Significantly! However the way different lenders price in risk is proprietary knowledge to that business and differs markedly between lenders. The result is that larger loans, with low perceived risks can be priced at very close to residential mortgage rates, smaller deals but more particularly higher risk deals attract far higher interest rates.
How do you ensure a good rate?
The same steps you would take in maximizing the chances of a good investment return:
- Purchase high quality properties, which would be easily re-let if vacant
- Buy properties with sufficient time left on the lease to allow a reasonable loan term (preferably at least 3 years)
- If the lease is long make sure there are market reviews so you aren’t left with an asset that is underlet for a long period
- Make sure there is security against the lease. This can be achieved by way of personal and corporate guarantees (which is most appropriate depends on the nature of the tenant, a corporate guarantee from Coles is sufficient but is not from a small business), bank guarantees or significant funds bonded in trust also provide good security against default by the tenant
- A financially strong tenant is very attractive to lenders. For this reason companies that are publicly listed or otherwise well known are an attractive proposition to lenders
- Properties with multiple alternative uses are generally perceived as being lower risk than more specialized assets e.g. there are more alternative uses for an office than for a Motel. Where the asset has a specialized use, it is important that there is very strong demand for that style of property, the quality of the tenant and lease are also more important in such circumstances
- A strong rental return that allows for a significant buffer above interest cost
