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The Fundamentals Of How Lenders Assess Risk - Commercial Property

This article is on understanding the fundamentals of how lenders assess the risk of lending into the commercial property market. One of the biggest misconceptions is that the same lending rules apply. This is not the case.

The risks of commercial property differ from residential property in a number of ways. These differences lead to different lending criteria being applied.

However there is one fundamental factor that remains the same for buying commercial property and residential property in regard to assessing the risk profile of a property and that is the location of the property. Commercial property suffers from the same risks in this regard as residential. Good commercial locations will always carry a lesser risk in terms of capital protection, growth and tenant demand than the less desirable locations where the risk increases.

Lenders however take a much more conservative approach to lending on commercial property, particularly in the area of the level of debt they will allow you to borrow against a commercial property. With residential property you can borrow up to 90% to 95% of the value or purchase price of the house where as the norm for commercial property is 60% to 65%. Some lenders will go up to 75% or maybe 80% but that is about it.

This indicates that commercial property is not as easy to exit from than is residential property and therefore it requires you to have a much greater equity available to purchase a commercial property than a residential.

Why is this? The primary reason relates to what is known as the tenant risk. Tenants for commercial property are businesses in their own right and the risks are assessed as follows:

• What type of business is the tenant in • How long has the tenant been in business • What is the financial strength of the tenant • How long is the lease • How long has the tenant been there

The type of business has an impact on a lenders view for a number of reasons for example;

• Is the business in a sector that is considered economically viable for the foreseeable future • Is the business in a highly competitive market • Is it a business that carries environmental risks (chemical use etc)

How long the tenant has been in business and how long has he been a tenant are two of the few signs of their financial strength or otherwise. A commercial property owner rarely has access to the financial accounts of the tenant to otherwise assess their financial strength.

Lease Term

From a lenders perspective the length of the lease is a major factor in assessing the lending risk of the property. Unlike residential leases commercial property leases are for fixed terms and these vary from 6 months to 5 years with the norm being 3 years. There is generally Right of Renewal provisions in the lease that gives the tenant the right to renew and rent reviews at intervals as agreed between the parties.

Lenders do not like short term leases as the tenant can leave at the end of the term leaving vacant space and a substantial drop in the borrower’s cash flow.

You might say that most of this is the same as applies to residential but the important difference is that commercial tenants are income generators whereas residential tenants are generally income earners. Commercial tenants are more susceptible to market factors and therefore the rental income is at greater risk if the tenant is not in a strong financial position.

Tenants

Finding tenants for commercial property is not as easy as finding tenants for residential property. The demand is dependent upon location, the design and use of the building and how specialised it is. It is not like a house that generally is a house for the purpose of living. A commercial property is generally designed for a specific reason. Of course economic forces then come into play as to how much in demand a particular type of commercial property is at any one time.

The types of property range from Retail (shops), office, office warehouse to industrial and lenders will each have a view on each sector as to the perceived risk profile. The comparison in the residential market is apartments, townhouse and houses but here each serves the same purpose.

Debt Servicing Criteria

Finally debt servicing criteria relating to commercial lending is not the same as residential. With commercial property the rent received will be related to a multiple of the cost of debt. For example generally the minimum multiple is rent to equal 1.5 times debt cost. If this doesn’t work borrowers have to have alternative surplus income.

Commercial property by virtue of their longer term leases can provide a good investment opportunity with excellent growth opportunities but it is important to understand the different risks involved and how they are perceived by lenders.

Rob Tucker 1