Commercial property: Mixing business with pleasure

By Nila Sweeney

 “Most people like to have a mortgage on a commercial asset because they are still emotionally reserved about securing a commercial mortgage on the family home” Richard Aulsebrook, Morgan Brooks Direct

“Do the sums: how much rent are you paying? Ask yourself: do I get a better return on my capital by investing my funds in my business, or in holding property?” John Macalyk, AAA Commercial Mortgages

As residential property markets around the country continue to grapple with post-boom hangover, commercial property is following a distinctly different trajectory.

Office, retail and industrial property yields are currently enjoying a renaissance of late, with yields beginning to move north of 6% in retail, office and industrial property alike. On the contrary, with constant pressure on residential yields in many capital cities due to investor nerves and tightening rental markets, you’d be lucky to find an investment that delivers more than 3%, according to research from Residex.

Investing in commercial property isn’t nearly as scary as it sounds. Best of all, you needn’t be in business yourself to enjoy the rewards of a commercial investment. And if you do happen to own a business, have you calculated how much you outlay in rent each year? It could well prove more cost effective to buy rather than lease.

The commercial lending landscape is now a markedly different world compared with 10 or even five years ago, with more lenders getting involved. It’s no longer the domain of the banks. “Non-bank lenders are asking themselves – how can we cash in on the commercial boom?” says Richard Aulsebrook, CEO of Morgan Brooks Direct. This means greater choice, lower rates, more flexible terms and a willingness by lenders to go out of their way to win your business.

Choosing a commercial investment

Traditionally, people have been wary of buying businesses as a way to house their savings or build a nest egg. “The main reason why mum and dad don’t often go into commercial is because of difficulties in lending to tenants. When a lease expires, it’s easy to find tenants to fill a house, but it’s harder to find new occupants for a factory. Also, it takes longer to sell a commercial property – it can take up to six months,” says John Macalyk, managing director of AAA Commercial Mortgages.

Perhaps the single biggest factor in evaluating whether or not to purchase a commercial property is the quality of the lease, and it’s expiry profile. An office with a stable, long-term tenant on a 10-year lease will be far less volatile than one whose lease is on the brink of expiry.

Making an effort to understand the business that the tenant is in will greatly assist you in uncovering a sound investment. Other things to note about the property include: it’s location in terms of proximity to transport as well as its flexibility – how easily can the fit-out be tweaked to accommodate different tenant companies?

Commercial property investments are also subject to the business risk of the industry that the tenant operates in – for example, if you buy into a bulky goods warehouse and consumer confidence suddenly plunges, you may run into difficulties. That said, renting to a profitable, stable multi-national company or even a government department reduces the chances of your tenant defaulting.

Rent or buy?

If you own a business and rent your premises, the decision of whether to lease or own the property has probably crossed your mind. It is essential to do the sums to work out the relative costs and benefits of each course of action. How much higher will the mortgage repayments be than the rent, and is it worth forking out a little extra so you can eventually own an income-producing asset outright?

“As a tenant, you will be paying more and more every year. Do the sums: how much rent are you paying? Ask yourself: do I get a better return on my capital by investing my funds in my business, or in holding property?” advises Macalyk.

Leasing can be a sensible option in an environment of rising interest rates, but it doesn’t generally pay off when inflation is also creeping upwards. According to Macalyk, “There are usually ratchet clauses in the lease stipulating that every 18 months your rent is adjusted upwards in line with CPI – which is now 4%.”

Home or office?

If you are purchasing a property for your business, or making a passive commercial investment, the first decision you need to make is how you will secure the loan. You can either use your own house, or another residential property, or you can use the commercial premises you are purchasing.

Securing a commercial property on your home has important cost advantages, including a lower interest rate, fewer fees and the ability to borrow up to 100% of the property’s value. Because you are using an asset you already own as security, you may be able to finance your deposit via equity, rather than cash.

Your mortgage will be classed as a home loan, which means you can borrow for a term of up to 25 years. You can keep the repayments for the commercial property separate, and even pay interest-only to maximise the tax benefits. Borrowing in this way could well work out cheaper, but you must be extremely careful not to over extend yourself.

“Most people like to have a mortgage on a commercial asset because they are still emotionally reserved about securing a commercial mortgage on the family home. But realistically, you need 25% equity just to play in the game,” says Aulsebrook.

Indeed, the entry costs of taking out a commercial loan can prove prohibitive. Until recently, lenders were loath to advance a borrower greater than 65% of the commercial property’s value, but increased competition has pushed this up to 75%. Loan terms used to last only five years, but these are also being extended to 15, 20 and 25 years.

Risky business

Another fundamental distinction between a residential loan used for commercial purposes and a commercial loan is the way in which lenders decide on your interest rate. Commercial lenders tend to follow a ‘rate for risk’ procedure, similar to that of low documentation loan lenders.

Basically, the greater the risk that the lender perceives in lending to you, the higher the interest rate you will be charged. Commercial loans are based on the bank bill rate plus a margin indicative of the risk level. (The bank bill rate is the rate that at which the banks buy and sell money from each other.)

Your commercial loan rate will also be a function of the size of the loan relative to the value of the property you are purchasing. Put simply, the higher the loan to value ratio, the higher the rate you will be charged. All other things being equal, interest rates on commercial loans tend to be 1-2% higher than home loans.

Bookallil brothers take control

Brothers Mark and Phil Bookallil had been running their IT business Cityweb out of suburban office space in Sydney’s Randwick for a number of years. When their lease expired in 2005, they decided to take stock and do the sums. Rent versus buy.

Currently it was costing them over $30,000 annually to rent the premises. The pair decided to investigate the relative costs of purchasing a similar office.

“There’s about a $50–$100 difference between monthly rent and mortgage repayments, including principle and interest and not just the interest-only payments,” says Phil. But purchasing an office gave the brothers an added boost – for much the same money, they could move into a refurbished space and thus save themselves the hassle of renovating the existing office, which had become rundown.

Another thing the Bookallils disliked about renting was the regular rental increases that commercial tenants are subjected to. Furthermore, the pair rapidly realised that if they were also prepared to secure the loan against a residential asset, they could potentially save themselves thousands of dollars in interest.

After searching extensively for suitable premises, the brothers found an office with a showroom in a commercial development in nearby Waterloo, a stone’s throw away from both the CBD and Sydney Airport.

“I’ve done a lot of research on the area and basically the Redfern/Waterloo area is being planned to become the extension of the Sydney CBD. This particular office is right in the middle of that commercial corridor, and prices are extremely negotiable at the moment,” says Phil.

By combining the equity in their respective homes, which had a value of close to $1.1m, Mark and Phil took out a loan for $550,000 to purchase the property and cover the initial fit-out.

“We have a fairly flexible loan, in that we can put all of our business money into it and we can basically pay all of our clients and suppliers out of the same account. It’s like a very flexible offset account – you can even have your own business key cards attached to it,” explains Phil.