Property Investment Lending

Commercial Property Investment - 10 Questions Answered

29th Apr 2024 | Ben Pauley


We have created a list of the questions we are most frequently asked about commercial property investment. It is important to be aware of these different elements before moving forward with your commercial investment.

What is NET rental income?

Net rental income refers to the income on a property after all operating expenses (OPEX). This accounts for the gross income less any operating expenses. Operating expenses would include things such as rates, insurance, utilities, maintenance etc.

It is important to understand your net rental income as this is the income that is available to service debt and provide you a return.

Is it only banks that lend against commercial properties?

No, there are many non-bank lenders that will look to lend against commercial property. These lenders tend to have a higher cost structure than a bank (see below), however may be more aggressive which can suit for short term bridging.

What is the maximum Loan to Value Ratio (LVR) for commercial property?

Lenders, particularly banks, have different Loan to Value Ratio (LVR) thresholds for commercial property than residential lending. Where you may be able to borrow up to 80% on a residential property, commercial property typically taps out at 65%.

There may be some lenders, outside of the main banks, that will accept higher LVR’s (up to perhaps 70%), however this would be on a case by case basis.

You could also, where appropriate, attract mezzanine finance on a commercial property which would increase the level of leverage.

What is an Interest Coverage Ratio ?

The primary servicing mechanism for commercial property is the Interest Coverage Ratio or ICR. This is a measure of how many times the Net Rental Income covers the interest expense of the loan.

It is simply calculated as the Net Income / Interest Expense. For example if your property has gross rental income of $120,000.00 and $20,000.00 of OPEX then your net rent will be $100,000.00. If your interest expense is then $50,000.00 the ICR is 2x ($100,000.00 / $50,000.00).

Lenders will seek out different ICR’s depending on the market cycle and their risk tolerance. A bank may want an ICR of 1.50 – 2.0x whereas a non-bank lender may be more comfortable closer to 1.0x.

How much does commercial property lending cost and how does a bank determine the interest rate?

Commercial property lending varies in cost, however, typically a bank will require a margin of 2 – 4% above their cost of funds (think OCR). They may also charge an establishment fee of up to 1% of the loan amount on drawdown.

Non-bank lenders will charge a little more, some are as low as 9 – 10% on an interest rate (only slightly above the banks currently) but perhaps 1.5 – 2% on an establishment fee. Others will be low – mid teens on the cost of debt (i.e. 12 – 15% total cost).

Banks will determine their interest rate based on risk based pricing (link to that blog). Risk based pricing is where the bank will input the relevant facts about the loan such as the WALT, ICR, loan term, tenant profile etc. to determine the risk of default. This coupled with the LVR will determine how much capital the bank is required to allocate against the loan and the bank will then have a predetermined margin it needs to achieve to meet its return hurdles relative to that capital and that will be added to the banks cost of capital.

i.e. if the banks cost of capital is 6% and the risk modelling dictates a margin of 2.5% is required on the loan then the overall rate will be 8.50%.

What is a Net Lease?

A net lease refers to a lease where the tenant funds some or all of the OPEX for the property. A triple net lease would mean the tenant is covering all the OPEX on the property including any rates, insurance and maintenance.

There are, however, other forms of lease which may mean that the landlord covers some of the OPEX (I.e. not fully net). Any form of a net lease is preferred as it means some or all of the OPEX is covered and you have a level of protection against cost increases of this – see insurance costs in Wellington.

What is a WALT and why is it important?

A WALT is a weighted average lease term. It is a method to see what the average remaining lease term is on a commercial property (or multiple properties) with different tenants. The lease terms are weighted by their share of rental income to provide a weighted average of the remaining lease term.

This is important as funders, banks in particular, will look to match their loan term to the WALT. This manages the risk of leases not renewing for the funder and forms a natural point of review of the risk of the lending. If the loan term is greater than the WALT then this could be considered of greater risk and therefore carry a greater premium on pricing.

What is NBS rating and why is it important?

The NBS rating is the National Building Standard rating and is normally shown as a percentage of that. What it represents is how the property looks next to the national building standard and what percentage it is currently built to that standard. For example a building may have a NBS rating of 30% indicating that it is only up to 30% of the building standard. Others may have over 100% indicating they are built at a specification higher than the building standard.

It is an engineering standard designed to illustrate the structural capacity of a property.

The NBS is important as post the Christchurch earthquakes legislation came in requiring that buildings be greater than 67% of the NBS. This is being phased in over time, however, properties with a NBS less than 67% will need to be bought up to standard which can be costly and involve a significant amount of engineering work.

It is important to understand this as it may impair a lenders amount or ability to lend on a property. Banks, historically, have not lent against properties with a NBS rating of less than 35% and anything between that and 67% would need to provide a cost estimate and programme to be rectified with those costs being netted off the loan amount to ensure there is headroom to fund.

What is a cap rate?

A cap rate (or capitalisation rate) is the rate of expected return for a property. It represents, as a percentage, the return you should expect on a commercial property asset. It is relative to the riskiness of the asset. The riskier the property the higher the cap rate or return you should expect.

It will, therefore, differ between property types (i.e. an industrial property will have a lower cap rate than a retail property), location (a city centre will attract a lower cap rate than a regional property), tenant profile, market cycles and what returns you can achieve elsewhere on other investments (if a lower risk investment like a term deposit attracts a 4% interest rate you can expect cap rates to be higher).

The valuation of a property is therefore determined by the rental income divided by the cap rate. i.e. a property with $100,000.00 of rent and a cap rate of 5% would be worth $2,000,000.00 ($100,000.00 / 5%). You can therefore easily unlock value if you can identify assets that are under-rented (rents will go up and therefore value) OR that are likely to have their cap rates improve (perhaps a better tenant or lease term is expected).

Why are the loan terms so short?

Regulatory requirements dictate that a bank cannot extend beyond 15 years for a commercial property loan. Despite this, many commercial property loans are 5 years or less.

There are two primary reasons for this. Firstly, a shorter term means that the risk of the loan is lower resulting in a lower cost of the debt. The simple way to think about this is that the further we look forward into the future the less certain it becomes and therefore the risk profile is higher commanding a higher capital allocation and thus the cost of that capital.

The second reason is more commonly run against, this is that the bank will typically not lend beyond the lease term on a property to avoid the event where the tenant does not renew and the loan remains outstanding with no clear point of review. One of the greatest risks for commercial property is the loss of the tenant and thus income to service the loan. Banks seek to avoid an instance that this happens without a point for them to review.

Does this mean you need to repay the loan within the lease term? No – see balloon payments below.

What is a balloon payment?

A balloon payment is a large one off payment at the end of a loan term. As mentioned above, banks typically do not extend commercial property debt beyond 5 years. However, they will accept repayments being made as if the loan were over a 15-year term OR, if the leverage is deemed low enough, even a full interest only loan with no capital repayments.

In this event, at the end of the loan term there is still a balance outstanding and this is what forms the balloon payment due

Normal practice is for the loan to be renewed at the end of the loan term rolling over the outstanding balance. The balloon payment is therefore made with a new loan for the remaining balance. There may be instances where a bank does not renew a loan however. These would typically be in instances where the risk profile of the loan has stretched beyond their appetite. This may be a result of a lost tenant, property damage or poor account conduct.

In most instances, however, the bank will rollover the loan.

As always reach out if you have more questions!

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