If you’re an experienced residential property investor, often the next step in your investing journey is diversifying into commercial property. Buying a commercial property can also be a great long term investment for a business owner, rather than renting. Let us help you navigate the process, the structures, and lender choices, when looking for a commercial property loan.
Why invest in Commercial Property?
Investing in commercial property has several advantages over investing in residential property, including:
- Higher yields – rents are typically higher relative to the value of the property
- Diversification – commercial properties can follow a different market cycle, giving you exposure to growth when residential property isn’t doing as well
- More flexibility – you can do more with a commercial property, such as subdividing the property into subtenancies and setting up multiple streams of income
- Tenants pays outgoings – you can negotiate for the tenant to pay all property related expenses, even land tax in some leases
- More business friendly – a commercial lease is a business agreement and is not covered by consumer tenant protections
How is a Commercial Property different from a Residential Investment Property?
While there are some overlaps, there are also some important differences:
- Deposit requirements are often higher for Commercial Property
- GST is payable on a Commercial Property if it is purchased and settled with vacant possession
- Projected rental income – if there is no signed lease in place at time of settlement, no rental income can be applied to loan servicing. This is a very different servicing treatment to residential investment loans, which can use the projected rental.
- Establishment fees can be charged to secure the finance, and more of the transaction costs are passed onto you such as valuation and legal fees
- Interest rates are typically higher when taking a commercial property loan, with lenders adjusting the rate for the risk
- There are many different categories of commercial property, including ‘specialised assets’ – see below
- There are fewer banks available who can finance commercial property, making it even more important to get your ducks lined up, and your application approved the first time. However, there are more loan options in terms of private lenders.
- Loan terms vary greatly from anything from 6 months for a private loan to 30 years for a non-bank commercial loan
- Leasing arrangements for commercial property are very different – outgoings are subject to negotiation, lease terms are usually set in years, and option periods may apply
- More innovative structuring arrangements are available to you such as purchasing the property in a separate entity to your business or your SMSF
- A Commercial Loan is unregulated from a consumer protection point of view
What are types of Commercial Property Investments?
The most standard types of commercial investments are as follows:
- Commercial Office – premises usually for professional services, corporate offices, or where goods sold are not bulky, and the business does not require pedestrian foot traffic to be found. Commercial offices are usually graded into A, B or C Grade, and also categorised as CBD, CBD-fringe or suburban.
- Commercial Retail – showrooms and shopfronts, they can be in ‘strip mall’ locations such as Oxford Street in Paddington or King Street in Newtown. Alternatively, they may be in small regional shopping centres or neighbourhood shopping precincts. Bulky goods centres or large display rooms may double up as warehouses and tend to overlap with industrial property.
- Industrial Properties i.e. Factories & Warehouses – premises that produce, store, or display physical goods, either in large quantities or of a bulky nature. Industrial properties are typically storage facilities or large open areas which are either fitted out or laid out for a specific purpose, for example, a production line, the setting out of work stations, food processing, or palletisation of finished goods.
- Blocks of Units or Developer Residual Stock – residential loans can only be considered for a certain number of dwellings in the same unit or apartment block. Where the number of dwellings held exceeds that threshold (usually 4 to 6), banks deem the properties commercial in nature, even though individually they are residential properties.
- Mixed Use Properties – these are properties that have both residential and commercial tenancies but are on the same title. For example, the ground floor may be a shopfront, but the top floor may be rented out as a home.
Specialised Commercial Assets can include:
- Hotels/motels
- Pubs & clubs
- Special purpose built medical facilities such as day hospitals
- Childcare centres
- Aged care centres
- Petrol stations
- Churches and places of worship
- Agricultural properties
How should I hold my Commercial Property Investment?
Just like when starting a business, there are structures in which you can hold your Commercial Investment Property. Most clients will consider investing using a:
- Family Trust – if the intention of the trust is to just hold investment property
- Unit Trust – if they would like to invest with other partners
- Self-Managed Super Fund – if you have a sufficient deposit and would like to invest for your retirement
- Company – if you are holding retained profits in an established entity
It is very rare for a commercial investment to be held personally due to the personal liability risks and tax implications when the property is sold. We recommend seeking your accountant’s advice on the best structure for you.
How is my borrowing capacity assessed for a Commercial Property Loan?
There are two ways that serviceability can be assessed for a Commercial Investment Loan:
- A Group Servicing Assessment – this is similar to a residential investment loan application, where all the net income you earn personally, from your business and from your investments are matched against your loan repayments and personal commitments to see what cash flow is left over for loan servicing
- “Lease Doc” Servicing Assessment – this is when your borrowing capacity is assessed based on the net rental income alone (see below for further details)
When a Group Servicing Assessment is applied, more flexible terms and longer loan durations are usually allowed, as there is additional security beyond just the lease agreement.
What are the key considerations for a “Lease Doc” Assessment?
It is very important that the Commercial Property has a signed lease agreement in place at the time of settlement for the rental income to be applied to loan servicing, this is both under a Group Servicing Assessment or a Lease Doc Assessment.
If the property is settled with vacant possession, then the Lease Doc method does not apply.
To establish your borrowing capacity under the Lease Doc method, a lender will take the following steps:
- Derive the net rental income, that you will receive as the landlord
- Apply a minimum Interest Coverage Ratio (ICR) that you must satisfy – this is the multiple of annual interest costs the rent must cover for a given interest rate
- Apply the interest rate given the riskiness of the deal presented
- Backsolve the maximum loan amount given the required and interest rate applied
For example, for a commercial property where the net rent is $100,000 pa, required ICR of 1.5x and interest rate of 7.5% pa, the maximum loan amount on a Lease Doc basis is roughly $888,000.
| Net Rent | $100,000 | (A) |
|---|---|---|
| ICR | 1.50 | (B) |
| Assumed Interest Costs | $66,667 | (A) / (B) = (C) |
| Interest Rate | 7.5% | (D) |
| Maximum Loan | $888,889 | (C) / (D) |
What is the deposit and loan repayments required?
As mentioned, the deposit and fees are typically higher for a commercial investment property than a residential property.
For a bank, the typical maximum LVR for a commercial investment property is 65%. Banks apply a lower LVR as a commercial investment property carries more risk, as they are harder to lease when vacant and take longer to sell given there are less buyers than for a home.
Non-bank lenders can often take on a higher LVR, for example 75%, however they will charge higher interest rates and establishment fees.
It is important to remember that, when the Lease Doc method is applied, it is very rare that the maximum borrowing capacity will reach the maximum allowable LVR, especially when interest rates are high. This usually means a large deposit is required when applying for a Lease Doc loan.
An example is provided below of the different deposit required, expected costs, and indicative loan repayments for a $2M Commercial Investment Property.
| Purchase Price | $2,000,000 | $2,000,000 | $2,000,000 | $2,000,000 |
|---|---|---|---|---|
| Stamp Duty | $94,000 | $94,000 | $94,000 | $94,000 |
| Transaction Costs @ 1% | $20,000 | $20,000 | $20,000 | $20,000 |
| Total Costs | $2,114,000 | $2,114,000 | $2,114,000 | $2,114,000 |
| LVR | 75% | 65% | 55% | 45% |
| Loan Amount | $1,500,000 | $1,300,000 | $1,100,000 | $900,000 |
| Total Contribution | $614,000 | $814,000 | $1,014,000 | $1,214,000 |
| Add 10% GST | $200,000 | $200,000 | $200,000 | $200,000 |
| Total Contribution Including GST | $814,000 | $1,014,000 | $1,214,000 | $1,414,000 |
| Loan Repayments @ 7.5% P&I | $11,085 | $9,607 | $8,129 | $6,651 |
| Loan Repayments @ 7.5% IO | $9,375 | $8,125 | $6,875 | $5,625 |
What are the other costs involved?
You can generally expect to incur larger transaction costs for a commercial investment property than a residential property, including:
- An engagement fee / mandate fee / initial work fee
- A lender establishment fee
- A brokerage commission of “Success Fee”
- Valuation fees
- Legal fees
- Administration
Typically, all or a portion of a broker’s commission is paid for by the lender’s establishment fee.
At SF Capital, there is no cost to conduct an initial assessment and provide our initial recommendation. A formal quote will then be provided if you would like to proceed with our services, outlining our Success Fee and/or any broker commissions we earn.
If you are working with a broker and the broker’s commission is not disclosed to you, there may be a case of ‘double dipping’ without you knowing, which is a practice we frown upon.
What are the risks?
While there are many advantages of investing in Commercial Property, there are also many risks, namely:
- Longer vacancy periods – if a lease ends, it may take longer to find a new tenant
- Longer selling periods – the pool of buyers is less for commercial property than residential property
- Lower capital growth – historically, residential has experienced more growth than commercial property, with some sectors struggling like commercial office
- Lower LVRs and borrowing capacities – this means you need a higher deposit
- Less lender choice – while there are many private lending options, there are less options from institutionalised banks and non-bank lenders
What is the process?
Our Commercial Property loan process has the following steps:
- Understand goals and scope
- Collect supporting documents (Phase 1)
- Initial assessment
- Workshop with bankers
- Discuss and decide
- Collect additional supporting documents (Phase 2), including Signed Lease Agreement
- Prepare Credit Paper
- Submit loan application / formal credit testing
Why should I use SF Capital for my next Commercial Property Investment?
At SF Capital, we go the extra mile to assist with your commercial property needs. We offer several advantages that set us apart from going directly to the bank or considering other brokerage firms.
Expertise – We are passionate about business and specialise in helping business owners. We understand how to read complex financials, understand how businesses are structured, and work hand in glove with your accountant to get you the best result.
Experience – We have settled many Commercial Property Loans of varying sizes and degrees of difficulty. We have assisted with small office refinances, large commercial purchases, property development, and residual stock loans. We are highly experienced in Full Doc, Alt Doc, specialist, and private lending.
Process – We run a tight process that keeps you informed and leaves nothing on the table to ensure you get the best deal for your Commercial Property loan. This involves intimately understanding your financials, preparing a detailed credit paper which makes your case, and brokering your loan out to our lender panel to obtain offers for you.
Save Time – Our process saves you time, as we present all information a lender requires to evaluate your scenario upfront. We also manage the back-and-forth with the bank for you, so you can keep focused on running your business.
Secure the Most Competitive Deal – Our process also entices lenders to “compete” for your deal and offer the best terms. Essentially, we run an efficient tender process which encourages lenders to put their best foot forward as well as manage the negotiation on your behalf to secure you the most competitive loan terms.