Earlier this month we discussed the fundamental differences between residential and commercial property loans. With the surface now scratched, we expose the differences between the two lending types as seen by bank managers, loan officers, and credit managers (with whom the buck sometimes stops).
Who Is the Tenant?
A tenant of a residential investment property will usually need to have just one proven attribute – the ability to pay rent. Whether an existing or new tenant, the bank will want to see either a signed lease agreement in place or proof of rental income having been paid regularly and on time.
If that box is ticked, you’re one step closer to an approved investment property loan.
As the value of a commercial property transaction can be heavily impacted by the strength of the tenant, the bank or credit manager will look at a tenant much more closely when assessing a commercial property loan.
It is certainly a good thing to have a strong tenant in your property; taking up a significant NLA with a long, profitable lease.
However, if this ‘anchor tenant’ is removed from the property, it is extremely important to understand and consider the effect it will have on the property’s Weighted Average Lease Expiry (or WALE – discussed in last week’s post).
The bank will find comfort if the property is occupied by a large company with a national or international presence, or even occupied by a government department.
I.e. Kathmandu, and their impressive historical performance, will have much more appeal over an independent hiking store with a track record of just a few years.
Leasing history & options
Does the tenant have a history of renewing their lease? And are there options attached to their existing agreement (permitting the lessee to renew for an agreed period of time)?
These questions will help the bank see what the future occupancy of the property may look like.
How Is Rental Income Considered?
A serviceability calculator is used to ensure that there will be enough income derived from the property (and primary income) to service the new loan, with the applicant’s existing debt commitments and regular expenses taken into account.
The bank will be looking for the serviceability calculator to produce a ‘surplus’ (i.e. where income is greater than the minimum loan repayments plus expenses).
As a high-level example, Sarah wishes to take out a 30-year investment property loan of $500,000, with principal and interest repayments of $2,700 per month. The bank calculates Sarah also repays $2,300 on her credit card each month and has monthly living expenses of $2,000.
For her loan to see an approval based on serviceability, her total monthly income will need to be at least $7,000.
A key measurement used in assessing commercial property loans is the Interest Coverage Ratio. This ratio suggests how easily a landlord will be able to pay interest on the proposed debt and is one of the most used measurements by commercial bankers.
Using the property’s earnings before interest and tax (i.e. gross rental income less expenses, before interest and tax obligations), the Interest Coverage Ratio is determined by dividing this figure with the proposed interest obligation.
Consider a commercial property which receives earnings of $100,000 per year (before considering interest and tax obligations). The bank is suggesting the new loan’s annual interest will equate to $40,000. This results in an ICR of 2.5.
Banks will typically look for an ICR of 1.5 or above. Anything below this may cause the credit manager to challenge the proposal… or provide the applicant with a simple “no”.
Difference in Property Valuations
A residential property market valuation is typically a short two to five-page document, which is primarily used to ensure the property’s fair market value is consistent with client and bank expectations.
A residential valuation is relatively simple, with methodology always based on a ‘direct comparison’ to similar properties that have recently sold.
It will also display certain important characteristics such as title details, environmental risks in the area, and the appropriate insurable value of the property.
Far from a short read, a commercial valuation report will potentially contain over 50 pages of dense analysis, commentary and, of course, disclaimers.
A market valuation of a commercial property for a bank must use more than one method of valuation, with the primary method usually being the Income Capitalisation Approach.
With this method, valuers will apply an estimated market capitalisation rate by analysing market evidence of characteristically similar properties. This is applied to the annual net income of the property and a market valuation then calculated (the ATO provides a good example here).
What Security Is Being Offered?
The typical security arrangement for a home or investment property loan will be the residential property itself.
Once the valuation is viewed, and the valuer confirms there are no nasty surprises, the bank may then look to take the property as security. A mortgage will be attached to the land title in favour of the mortgagee (i.e. the bank) until the loan is paid out and the loan agreement satisfied.
Collateral is a crucial part of any loan proposal. But in commercial property lending, it will go under the microscope.
How likely is the property to stand the test of time? Does it have flexible usage or adaptable building space? Is it classed retail, industrial or office, and what is the bank’s current appetite for each sector?
In some instances, where there may be blemishes on the transaction (i.e. low Interest Coverage Ratio, prospect of losing a tenant, etc), banks will seek more security than just the property.
A director’s personal guarantee or even a General Security Agreement (using company assets as security) may be required to improve the bank’s risk grading of the transaction.
Due to the quality of our transactions, Properties & Pathways projects are only financed by non-recourse borrowing arrangements, where only the property is used as security.
Understanding these factors is crucial for those in the buying process of such assets. Particularly for the financing of commercial property, it takes considerable experience to be able to put yourself in a banker’s shoes and ask, “does the bank have an appetite for this?”
Being prepared to present your commercial loan proposal to the bank is a crucial part of buying well and is thoroughly understood by an experienced commercial property syndicator like Properties & Pathways. For more information on how to invest alongside a knowledgeable investor, get in touch with us.