SME Finance – Commercial Lending
In working with SMEs, an important area for Business Finance Professionals is Commercial Lending. Many SME owners want to own their business premises, as part of their current thinking or future plans, and commercial loans are the mechanisms for them to achieve these goals.
Commercial Property loans come with a unique set of features, factors and rules that Business Finance Professionals and SMEs must navigate to secure the most appropriate finance options are considered for the take up of such a significant business asset.
Comparisons to Residential Mortgages
Essentially, the only point of commonality between a residential mortgage and a commercial loan is that the asset in question is real estate.
Residential Mortgages fall into two categories: -
The borrower resides in the property, and as such, there is no rental income from a tenant. It is a lifestyle asset with some capital gains tax exemptions when sold.
The borrower rents the property as an investment asset. Rental returns provide income to the borrower, and these vary between around 3% to 5% net. Interest payable on these loans is considered tax-deductible against the borrowers’ annual income.
Residential mortgages are mainly the domain of banks, credit unions and building societies. And when lending for residential mortgage purposes, these institutions pay particular attention and an almost sole focus on the borrower’s ability to service the loan interest amounts from their surplus personal income. They also view residential property lending as a means to leverage other banking and lending relationships with the borrowers.
Commercial Loans
The real estate used for commercial lending includes such things as office buildings, factories, warehouses, shops and retail outlets. Usually, these properties are rented to third parties with lease arrangements varying based on the lease term duration and conditions. The terms for commercial loans take into account usage along with the frequency and basis of rent reviews.
Rental income from commercial real estate is usually much higher than that received from residential property, typically netting a yield in the range of 4.5% to 11%, or even higher. The wide array is a reflection on the type of property, its location, the quality of tenants and their ability to continue making lease payments, as well as the duration, terms and conditions of the lease.
Commercials loans typically come at a higher interest rate than residential mortgages and the acceptable loan to value ratio (loan amount/value of the commercial property) usually is lower.
Commercial real estate loans are attractive to investors because they produce predictable and regular income with less risk than direct property ownership. The lower investment risk profile of a commercial property loan is directly related to the lower LVR - borrowers have a significant equity position in the commercial loan. For example, a LVR of 70% means the borrower has a 30% equity position creating a buffer before the property is in a loss position.
The providers of commercial loans tend to pay closer attention to the actual tenants and competition to the particular real estate asset. In general, the conditions and terms for commercial real estate loans are designed to establish boundaries, to which the borrower must adhere. To mitigate these loan risks, lenders can put the following conditions on commercial loans: -
Strict loan interest due dates
Set number of payments
Defined loan term
Default interest
Loan amount
Maintenance of the LVR during the loan term
A requirement for insurance to be in place
Handling and notification of tenancy change
Minimum levels of debt service coverage
Because of the complexity and variations in the commercial property lending space, lenders may seek to add additional layers of security by imposing other conditions such as personal and corporate guarantees from the borrower.
A failure by the borrower to meet agreed to conditions or special terms, or to rectify them within a specified period can result in penalties. Penalties can include an interest rate increase or potentially the trigger for loan default.
Specific Conditions
As mentioned, commercial property loans have unique conditions, factors and sets of rules that Business Finance Professionals understand and work with, in assisting SME to access the right amount of funding, at the best rate. The areas that Business Finance Professionals focus on, in relation to commercial lending are: -
Borrowing Limit
With commercial lending, the amount a SME can borrow is determined mainly by the security they hold. With a secured commercial property loan (a loan backed the collateral of a physical asset such as a warehouse), the SME could borrow up to 100% if they had a guarantor or additional collateral to secure the loan.
Notwithstanding this, the normal borrowing limits are: -
up to 80% if the property is valued up to $1 million.
up to 75% if the property is valued up to $2 million.
up to 70% if the property is valued up to $5 million.
For properties valued at over $5million, lenders will look at these on a case by case basis.
Mortgage Insurance
Because some Mortgage Brokers use lender’s mortgage insurance for residential home lending clients, they assume this facility is available for commercial loans. It’s not! If the SME doesn’t have at least a 20% deposit, they will need to rely on guarantees or put up additional collateral to enter into the loan.
Loan Period
Referencing residential loans, Business Finance Professional know these are amortized over the life of the loan so that the debt and interest are paid in full by the end of the term. An individual with a $200,000, 30-year fixed-rate mortgage at 5%, for example, would make 360 monthly payments of $1,073.64, after which the loan would re-paid in full.
However, commercial property loans typically range from terms of five years (or less) to 20 years, and the amortization period is usually longer than the loan term. For example, a lender offers a commercial loan with a seven-year term and an amortization period of 30 years. In this scenario, the SME would make payments for seven years based on the loan being paid off over 30 years, followed by one final balloon payment of the entire remaining balance of the loan.
For example, a SME with a $1 million commercial loan at 7% would make monthly payments of $6,653.02 for seven years, followed by a final balloon payment of $918,127.64 to pay off the balance of the loan.
The length of the loan term and the amortization period affect the rate the lender charges. Depending on the SME’s credit strength, these terms may be negotiable. In general, the longer the loan repayment schedule, the higher the interest rate.
Interest Rates
Commercial property loans are more complex than residential mortgages, which usually only look at LVR and the loan amount. As such, there is a disparity between commercial property lenders and the interest rates they offer. Each lender will use their own algorithm and risk matrix to determine their rate, but they usually consider the following: -
Property Details – the location, suburb, area; condition and appeal; competition and prevailing market; economic conditions
SME Details – net asset position; previous experience; track record; management team; ability to pay back the debt; industry sector
Loan Details - LVR; Lease Term, Tenants details
And, in general, the larger lenders have lower risk appetites and as such offer lower interest rates.
Fees
Commercial property loans usually involve payments that add to the overall cost of the loan, including establishment fees, early repayment fees, monthly fees and valuation/appraisal fees. It’s worth noting that commercial property valuations are generally more expensive than having a residential home valued.
Some fees must be paid upfront before the loan is approved (or rejected), and others are ongoing. Commercial loans can be quite large, and the additional charges involved can make quite a difference in the cost to the SME over time.
Reviews
It is common in commercial lending for the lender to insist on regular access to the SME’s financial details, so they remain satisfied with the stable financial position of the borrower.
For larger commercial property loans, institutions want to see the business financials annually, referring to BAS statements, Profit and Loss Statements and Income Statements to ensure the SME is in a position to continue to make the commercial loan repayments.
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