Last week, we shared some pros and cons of buying a commercial property because many people are now considering investing in commercial property. This week, we're going to continue with this topic and cover some of the areas that you need to consider if you are looking to purchase a commercial property to help you make a good purchase and also get your finance sorted smoothly.

What to consider when buying a commercial property?

Video Timeline

1. What areas do you need to consider if you're looking to buy a commercial property? - 01:00

2. Other areas that can't be overlooked - 11:58

1. What areas do you need to consider if you're looking to buy a commercial property?

(1) Location

Location, Location, Location. Similar to when buying a residential property, location is the most critical factor for capital growth. If you buy in a good area, it can help you minimise the asset value fluctuation and have the best chance of capital growth.

(2) If the build is purposely built

Not every type of building is equal. Some buildings are purposely built, such as daycare, petrol station, swimming school, motel, and hotel. If you are looking to purchase one of these commercial properties, you need to think about who your potential buyers will be when you're ready to sell or your tenants will be. The narrower the options, the higher risk it will be.

(3) Build type

Even when buying a generic type of building, you also need to think about who your potential tenants or buyers will be. Let's compare offices versus the industrial sector (e.g., factory or warehouse). During this Covid-19 period, many offices are empty now. With that said, if you invest in these types of offices, you possibly get a very short lease, or the tenants probably do not need much space anymore. In contrast, the industrial or warehouse type of property are in good demand.

(4) IEP report

IEP (Initial Evaluation Procedure), like earthquake rating report, is a percentage compare against the new building standard. This came about after the Christchurch earthquake – some buildings were damaged during the earthquake, and many people died as a result; therefore, the commercial building standards are important when it comes to purchase and become important for the lender to lend you the money to buy that type of property.

Also, from the bank's eyes, the IEP ideally needs to reach 67% or more. If slightly less than 67%, it doesn't mean it definitely can't be accepted, but you do need to calculate the cost and demonstrate your plan to bring it up to 67%. The minimum is probably 33% in order to get building insurance.

(5) Tenants' industry

Are your tenants in a declining industry (e.g., retail shops)? If so, the bank may be concerned because eventually they may not be able to afford the rent therefore expose to repayment risk

(6) Tenants' business

Even though the bank won't require a financial statement from your tenants(because it's confidential and the tenants won't give you that), you still need to look up their website and see how long they've been trading for and what kind of business they are in, so you can get an idea of how strong the business performance would look like. This is because a bank will do that type of due diligence as well when they make an assessment on your loan application.

(7) The number of tenants

Do you have one single tenant, or you have multiple tenants in the building? If you have one tenant, what if they leave? It's likely to take ages to replace the tenants. While you have multiple tenants in the building, if one leaves or if their business is not performing well, then at least you have other tenants, and it's not the same level of risk as single tenants.

(8) Lease term

If you look at the Deed of Lease, you will see the lease term has a plus sign following – the number after the plus sign basically means the tenants have the right to renew. For example, if the lease term states "3+3", it means after the initial lease term of three years, the tenants have the right to renew for another three years. But there's no guarantee that they will renew, so the bank will only look at the number before the plus sign. Typically, this lease term needs to be at least three years or more. Otherwise, the bank may not be comfortable lending you the money because the tenants can leave the building in a short time.

Normally the bank allows you to repay the loan over 15 years. However, the loan term needs to be aligned with the lease term. It allows them to review your situation to see if your current tenants can renew the lease or find a new tenant to replace the lease income, otherwise, you may face the risk of repaying the remaining loan, even though your loan still have 12 years repayment term . It's important that you make sure it has at least 3 years or more lease term when you purchase the commercial property for investment purpose.

(9) Rental Yield

One of the reasons people choose to invest in commercial property is the higher yield. With commercial property, you probably can expect a yield between 5-6%. So if you know the asking price and the lease income, you can basically work out the yield. In other words, if you know the rent, you can work backwards to work out the maximum purchase price you want to offer to stay in that yield range.

For example, there's one single tenant, and they can pay you for $50K a year (gross rent). The bank can allow 95% shading because there's the very little cost of owning a commercial investment property. The net income is $47,500 ($50K timed by 95%), and then divide it by 5%, so that gives you $950K, which means the maximum purchase you want to offer is $950k. If they ask more than that, you probably need to think about it twice.

(10) LVR

The Loan-to-value ratio (LVR) for a commercial property can be up to 65%, but it's case-by-case. If you buy a purpose-built property, like a daycare, you wouldn't expect 65% LVR, probably 50% instead. Or, if you have a single tenant, the LVR  is likely to be less than 65% as well. So, LVR is something that you need to be aware of, because it drives  maximum borrowing capacity.

(11) Servicing ability

Like a residential property purchase, the bank needs to look at how much income you have to service the loan. With a commercial investment property, they use the commercial income to evaluate your servicing ability. Currently, banks use the method of calculation called Interest Cover to work out the servicing ability. Basically, use gross rent time by 95% to get the net rent and then divide by interest cost. How is the interest cost calculated? For an indictive assessment, simple use the loan amount time by 4.5% (test rate), then use the net rental income divide by interest cost per year, and see how many times. If it's two times or more, it means you pass the test, and you can service this amount of loan. If less than 2%, then the bank may reduce your lending.

Servicing ability and LVR are the two most important factors when your bank calculated your borrowing capacity. We have a simple calculator for you to download. Input the asking price/maximum purchase price you want to offer and the rent, then calculate the maximum borrowing capacity you can borrow from the bank.

The above are the areas that you need to consider when it comes to buying a commercial property.

2. Other areas that can't be overlooked

If you start looking to purchase, say make an offer on a particular commercial property, please engage with your solicitor and accountant as early as possible. Your solicitor will help you work out what conditions you need to put in the contract and what kind of due diligence you need to do. With the accountant, they will help you figure out the best ownership structure.

Also, many people may think that once they purchased a commercial property, they can leave and forget it. Here's why not to. The bank will have ongoing requirements. For example, if your LVR is over 50%, they will require you to do a register valuation every couple of years so that the bank knows the value of the property. If it's less than 50%, there's a higher chance that the bank can waive that requirement. Also, they want to know the tenancy schedule, and make sure your tenants are still in place, giving them an early warning if your tenants leave.

Lastly, if you buy the commercial property for your own business, the loan-to-value ratio can be over 65% if your business performance is really strong, the bank is happy to lend you more. Thi is because you are effectively your own tenant. The 65% is secured lending against the commercial property. They can allow interest -only on this part of the loan, and then they lend you up to 35%, with the requirement of repaying the loan within up to five years. This part of the loan would be an unsecured loan, so the interest rate can be higher, but at least you don't need to come up with any cash deposit. Therefore it is possible to borrow 100% of the purchase price if you're using it for your own business, but your business must be trading for at least two years or more and  demonstrate your business can easily service the loan.

Now you should be able to understand what you need to consider when purchasing a commercial property. If you do have a commercial property you're looking to buy, it's best to get in touch with us, so we can help you get a personalized solution.

Read more:

Is commercial property now a more attractive investment than residential property?

Are higher interest rates coming?

Should you be concerned about DTI (debt-to-income ratio)?

Disclaimer: The content in this article are provided for general situation purpose only. To the extent that any such information, opinions, views and recommendations constitute advice, they do not take into account any person’s particular financial situation or goals and, accordingly, do not constitute personalised financial advice. We therefore recommend that you seek advice from your adviser before taking any action.