|
As a salesperson or broker specialising in commercial real estate it pays for you to keep up to date on the availability and types of finance that can apply to commercial real estate transactions. Most particularly the things that you need to monitor are the:
- Availability of funds
- Cost of obtaining funds
- Types of security required to secure the loan
- Qualification factors that apply to loans for investors
- The types of interest only loans available
- The types of principle and interest loans available
- The terms of the loans
- The loan value ratios that banks are providing loans on
We have produced this information paper to help you further understand the financing process that typically applies in commercial real estate sales and purchases. Given that you can work with numerous sellers and purchasers on many different types of properties, study the paper and review its impact on the types of properties in your area.
Get to know the bank managers or finance providers in your area and see what other information they can give you on the current mortgage market. Get the latest facts that you can on the finance availability in your sales area.
While commercial property is increasingly being marketed to smaller investors as a practical alternative investment to residential property, there are important differences between residential and commercial financing. Agents and Investors must be aware that the commercial property lending market is very different to the residential lending and it may significantly affect investors’ opportunities and returns on invested equity.
The commercial lending market has changed significantly over the last ten years. Once the domain of the traditional lenders (the big banks) the landscape has now changed with second tier banks, private lenders (wealthy individual syndicates) and superannuation funds (mostly the larger funds) now having entered the market.
The deregulation of the banking industry has attracted these new entrants into the commercial lending market and helped generate increased competition. However, the market still has some way to go in terms of product innovation, better pricing and changes in lending policies for commercial property.
The commercial lending market differs dramatically from the residential lending market, particularly in credit policies and product features. The maximum loan to value ratio (LVR) for commercial loans is typically 70%. In contrast, in the residential lending market you may be able to borrow up to 95% of a property’s value. There are a small number of commercial lenders that may lend up to a 75% to 80% LVR. The LVR can affect the interest rate - the higher the LVR, normally over 60%, the higher the interest rate.
This policy has two implications for Agents and commercial property investors:
Investors are required to contribute more equity into commercial property investments
The additional equity contribution is likely to reduce the investor’s return on equity compared to what may be achievable with comparable residential terms (i.e. being able to borrow up to 90%).
Investors can usually:
- Contribute more equity in order to minimise the interest rate e.g. borrow less than 60% or
- Contribute less of their own equity but pay a higher interest rate, as the LVR is greater than 70%.
Essentially commercial lenders and those linked to Agents offer two product types:
- A basic term loan, fixed or variable
- A line of credit
A basic term loan is one that is set over a fixed term; where the borrower repays principle and interest or interest only and there are no other features to speak of. These are typically referred to as ‘set and forget’ arrangements. Commercial lenders normally do not offer such features as offsets, redraw, introductory rates, etc, which are commonplace in the residential lending market.
In general, the more Investors borrow the more purchasing power they have. This is true for most things in life but it’s even more prevalent in the commercial financing world. For example, some lenders offer more competitive interest rates, i.e. within 0.5% of residential standard variable interest rates, to clients that borrow in excess of $1 million. Smaller borrowers may have to work with a higher cost of capital than larger borrowers.
Maximum loan terms for commercial loans range from 15 to 20 years, or 5 years for interest only loans. This increases the minimum principal and interest repayments compared to residential mortgages, which generally have maximum terms of 30 years.
Therefore it’s likely that commercial properties will be cash flow negative on a principal and interest basis. By comparison, similar yielding residential properties will be cash flow positive, even on a principal and interest basis. The leasing and property management processes on commercial become quite critical to the stability of the loan.
The shorter loan term also reduces the investor’s borrowing capacity as the minimum repayments are much higher than they would be with a longer 30-year term. Therefore, borrowers need to satisfy commercial lenders that they have the capacity to repay the loan over a 10 to 15 year period.
The most notable difference between residential and commercial mortgage loans is the interest rate. Commercial interest rates are generally in the range of 0.5% to 1.5% higher than standard variable residential interest rates.
While most investors are aware of the fact that commercial properties typically return higher yields than residential properties, it’s worth remembering that the cost of financing commercial properties may be greater as a result of the higher interest rates.
Most commercial property loans are priced on a case-by-case basis, depending on the individual strengths and weaknesses of an application. The interest rate charged will be directly impacted by the lender’s credit assessment. Factors that impact a lender’s risk assessment include:
- The property to be financed - in terms of condition, location, type etc.
- Strength of tenancy - in terms of existing lease terms, the quality of the tenants etc.
- Interest coverage - i.e. Does the borrower’s income cover the interest bill?
- LVR (Loan Value Ratio)
- Financial strength of the borrower - in terms of asset position, income capacity and creditworthiness.
One reason for the higher interest rates on commercial mortgages may be the fact that commercial mortgages tie up twice as much capital compared to residential mortgages, since banks must comply with the minimum capital adequacy requirements. As such, commercial mortgages utilise more of the banks’ resources and therefore cost the bank more than residential mortgages.
Commercial lenders normally focus more attention on the strengths and weaknesses of the security as opposed to the borrower. In contrast, residential lenders focus more attention on the strengths and weaknesses of the borrower.
You can expect the lender in a commercial real estate project or property to look at all the leases and the stability of the cash flow that is generated there from. This means an analysis of the rent reviews and the options that apply to the leases and how they impact the future of the property. Some leases are better constructed and designed for the performance of the investment and that fact will be seen and supported from the clauses of the leases in all the tenancies. Good commercial real estate agents take time to review all leases before proceeding to pricing and marketing a property for sale.
Application (or establishment) fees can range from 0.25% to 1.50%, or more, of the loan amount - a substantial amount in dollar terms. The average application fee for the loan is approximately 0.50%. In addition, borrowers are normally required to pay for valuation and legal fees.
Legal fees generally range from $800 to $3,000. Valuation fees can vary depending on the property type, e.g. specialised properties are more costly to value, but as a general rule, cost $1 for every $1,000 worth of value - therefore a $5 million property would cost approximately $5,000 to value.
Upfront costs can affect the financial viability of holding commercial properties on a short-term basis, commonly referred to as ‘flipping’ properties. Therefore, commercial lending cost structures better suit ‘buy and hold’ investment strategies. Other fees may include:
- Annual loan and valuation review fees
- Ongoing service fees
- Early repayment fees, sometimes referred to as break fees
There is no standard, or average, for the above fees. Agents and Investors consider all of these fees when calculating the overall cost of debt for a commercial loan.
In today’s market commercial mortgage lending is not as flexible and economical as residential mortgage lending. This can have a substantial effect on commercial property investors’ opportunities, with higher interest rates impacting on overall project returns and higher equity requirements, lower LVRs, reducing returns on equity.
With commercial property being increasingly advertised and advocated as an alternative direct property investment to residential, it’s important that, from a lending viewpoint, prospective investors understand the limitations and opportunities with commercial property investment. Investors first making the ‘jump’ from residential to commercial property are often surprised and disappointed with the differences between commercial and residential property lending.
The solution to this is to ensure Investors and Agents know exactly what they can and can’t finance before you decide to go down the commercial property investment road. It’s even more important to shop around for commercial financing to ensure Investors get the best deal.
It is clearly seen that new financial opportunities exist for Agents who establish good links to lending institutions that understand and service the commercial product well.
|
