It should come as no surprise that not all property investments are the same. There are many differences between investing in the residential and commercial property markets. One crucial area that many investors tend to overlook is finance. While you may be focused on location, attracting high-quality tenants and other issues, obtaining sufficient capital on favourable terms can make the difference between a successful investment and a money pit.
As the saying goes, ‘money makes the world go round’, and it’s certainly true when it comes to investing in commercial real estate. Access to capital is the lifeblood of the industry. So, what differentiates the finance market of commercial property from its residential cousin?
Perhaps an obvious difference, but a critical one, nonetheless. With a commercial investment loan, you can purchase pretty much any form of business property, including retail spaces, restaurants, hotels, and even medical centres. A residential investment loan, on the other hand, is essentially limited to houses, apartments or units. The risks associated with the various categories of commercial property can vary markedly and are far more sensitive to macroeconomic conditions. When searching for finance, it’s essential to understand how all these factors may affect future revenue streams and, by extension, the willingness of financial institutions to lend to you.
Loan-to-Value Ratio (LVR)
For a residential loan, most banks will allow you to borrow against 90-95% of the property value. Commercial real estate loans usually attract a much lower LVR of around 60-70%. The exact amount will be dependent on the lender’s policies, the borrower’s financial situation, and the potential rental income that can be generated from the commercial property. In light of this, be prepared to put together a far larger deposit than would be required for the family home.
Shorter Loan Terms
Standard loan terms are 30 years for residential property and anywhere between 15-20 years for commercial property. This means higher repayments, which you will need to prove to the lender that you have sufficient capacity to meet.
Interest Rates and Fees
Generally, interest rates for commercial loans are higher when compared to residential home loans. The higher fees are a means to offset the risk of potentially longer untenanted periods, which are part and parcel of owning commercial real estate. While both commercial and residential properties come with the risk of untenanted periods, these periods tend to be more common and significantly longer in the case of commercial property.
Having said that, this variable can frequently depend on the type of business behind the commercial property. For example, a small family run business applying for a loan may receive a lower interest rate, as the perceived risk is less pronounced. Conversely, a large hotel business, factory, office building or warehouse owner asking for a commercial real estate loan, will usually be subject to greater risk and, consequently, higher interest rates.
Lease periods for residential properties are typically around one or two years, and tenants are under no obligation to renew. Commercial property tenants usually commit to rental contracts for anything between 3-15 years. The longer lease periods, coupled with the fact that tenants of commercial properties pay their own rates, water and taxes, can serve to offset some of the other inherent risks and enhance your chances of a successful loan application.
Qualifying for any type of loan will naturally depend on the lender’s specific criteria. However, for commercial property loans, those criteria are almost always significantly stricter. It may feel like you’re jumping through invisible hoops, but that’s because commercial properties can be harder to sell if you default on your loan repayments. Setting the bar high is a de-facto insurance policy for the lender.
You’ll need to provide a valuation of the property with your loan application. With commercial properties, this valuation is far more detailed and costly to obtain than the equivalent service for a residential unit. Be prepared to provide a ton of paperwork and documentation.
With a residential property loan, as long as you meet the repayments, the bank or lender will generally leave you in peace. In the case of commercial loans, however, your bank manager or lending consultant will most likely take a more hands-on approach and maintain a more active relationship. It stands to reason that with the stakes significantly higher, a more involved relationship between borrower and lender is required to ensure that things are running smoothly on all fronts. Lenders may request regular updates on your financial status to make sure it’s looking healthy, and there’s no risk to the loan repayments. Some banks may want yearly reviews, while others will ask for them quarterly.
Financing a commercial property isn’t necessarily more difficult than applying for a regular mortgage. Nevertheless, there are numerous differences that the wise investor should be aware of before jumping in. As long as you keep these factors in mind and prepare accordingly, then you’ll be one step ahead in the commercial property game! For further advice on any aspect of commercial real estate, call MCO today. We’re Melbourne’s most trusted commercial real estate experts, and can help you succeed in this exciting field.