Refinancing a leased commercial property turns on the rent, the lease that sets that rent and the loan's own dates. The loan may have started interest-only, with repayments that cover only the interest. For an investor with one building and one tenant, the end of that period, or a lease with little time left, can change the repayment, the term on offer and the amount a lender can advance.
Is your interest-only period about to end, and will the rent still cover the repayment once principal is added? Does the tenant's lease have less than two years to run just as the loan comes up for review? Have the yearly rent reviews lifted the rent since you bought, while the loan was never revisited? And is your home still securing the line of credit, a limit you can draw on and repay, that paid the deposit?
Ardent Capital Group can arrange the refinance of the loan on your leased building and the borrowing beside it, and we would value the chance to go over the lease and the figures with you.
Why a lease running down puts pressure on the loan
An investment building earns its income from rent. With a single tenant, that rent is the whole income, and the lease decides how long it is promised for. When you bought, the lease may have had five or more years left. Each month since has taken some of that time away.
The loan has its own dates. This one started interest-only, so the balance has stayed the same. When that period ends, principal is added to every repayment, and the monthly cost rises sharply.
The lease and the loan can reach their deadlines close together. A loan review, an interest-only expiry and a lease with little left on it can all fall in the same year. A refinance is the point where the loan is set again around the rent and the lease as they stand today.
Example: an office building with one tenant and two debts
Putting numbers to one building shows how the pieces fit. These figures are illustrative. An investor bought a freestanding two-storey office building just under five years ago, leased whole to an engineering firm. The purchase loan was written over 15 years, with the first five interest-only, and one month of interest-only is left.
Part of the deposit was drawn on a line of credit over the investor's home. Both debts are set out with what secures each and what each costs a month today.
| Debt | Secured by | Amount owed | Rate (assumed) | How it is repaid | Per month now |
|---|---|---|---|---|---|
| Investment loan on the office building | The building | $1.5M | 6.8% | Interest-only for one more month, then principal and interest over 120 months | $8,500 |
| Line of credit used for the deposit | The investor's home | $85k of a $120k limit | 8% | Interest only, no set end date | $567 |
| Total | $1.585M | $9,067 |
The investment loan on the building is the debt about to change. Today the investor pays $8,500 a month on $1.5M, all of it interest. From next month the loan must repay principal as well, spread across the remaining 120 months, and the repayment becomes $17,262.
Against that, the tenant pays $150,000 a year in net rent, the rent left after the building's running costs, or $12,500 a month. The rent covers the interest-only repayment with room to spare. It does not cover the new repayment, which is $4,762 a month more than the rent. Each rate in this example was picked to show the sums, and none is a lender's rate.
What changes when interest-only ends
For an investor, the end of interest-only is when the loan starts reducing, and the repayment rises to pay for that. A refinance can reset the interest-only period, along with three other settings.
- The rate. A lower rate on the same balance and term means less each month and less interest across the loan. What a lender charges depends on the property, the lease, the tenant and the borrower's own credit history.
- The term. Spreading the balance over more years brings each repayment down. Because the balance is outstanding for longer, the total interest goes up. In the worked example, a 25-year term at an assumed 7.2% brings interest of more than the balance itself.
- How it is repaid. Where the lender agrees, the new loan can begin with another interest-only stretch.
- What secures it. Security is what a lender can sell to recover the loan if it is not repaid. Here, that is the building, and for the line of credit, the home.
A principal and interest loan is amortising, which means it runs down to nil by the end of the term, unless it ends in a balloon, a lump sum left to the final repayment. Interest each month is worked out on the balance outstanding, which is why the early repayments lean towards interest.
Worked example: the first principal and interest repayment
Looking at one repayment shows where the extra money goes once principal starts. In the first month after the switch, interest on $1.5M at an assumed 6.8% is still $8,500. The other $8,762 of the $17,262 reduces the balance. Over twelve months the loan falls to about $1.39M, roughly $108,000 lower.
The extra $8,762 each month adds to the investor's equity, which is what the building is worth minus the loan against it. It is paid from the rent and the investor's other income.
Refinancing the loan on a leased building
A lender can look at both the lease that produces the rent and the person or entity who owes the money.
Lease doc or full doc: the rent alone, or your income too
There are two broad ways a lender can assess this loan. The choice affects how much can be borrowed against the building.
- Full doc. The lender looks at your full financial records, including your own income, alongside the rent. On standard commercial property such as an office, full doc lending goes up to 80% of the property's value.
- Lease doc. The lender verifies nothing but the rent, so the lease carries the application on its own. Lease doc lending runs from 65% to 75% of value, tiered by the size of the loan.
That percentage is the LVR, short for loan-to-value ratio. On an illustrative valuation of $2.6M, the $1.5M loan is an LVR of 57.7%. That sits below the bottom of the lease doc range and well inside the full doc limit.
How long the new loan can run depends on the lender. The terms banks publish for commercial property are 10 to 15 years. Non-bank lenders publish 25 to 30.
What the lease sets out
The lease sets the building's income, so every part of it bears on the loan. These are the parts of the lease, and the figures worked out from it, that bear on the loan.
- Passing rent. This is the rent the tenant pays today under the lease, after every review so far. It is the figure a valuation can start from.
- Net or gross lease. Outgoings are the building's running costs, such as council rates, insurance and maintenance. On a net lease the tenant reimburses them. On a gross lease the owner pays them out of the rent. A valuer can work from the income left after outgoings, which is why this example uses net rent.
- The option. The option lets the tenant renew when the current term ends, on the terms the lease sets. Here the engineering firm has 18 months left and a five-year option it has not yet exercised.
- Rent reviews. A fixed review raises the rent by a set percentage each year. A CPI review follows inflation, as measured by the consumer price index. A market review, at an option or on a set date, resets the rent to what similar space leases for.
- WALE. The weighted average unexpired lease term, or WALE, measures how long the rent is promised for across a building's leases. With one tenant, it is simply the time left on that lease.
- Interest cover. A lender can test how many times the net rent covers the interest on the loan. Here, $150,000 of rent against $102,000 a year of interest is 1.47 times. Each lender can set its own measure.
The line of credit on your home
The line of credit is small beside the loan on the building, but it is the debt secured on your home. Interest is charged only on the drawn amount, here $85k of the $120k limit.
A refinance can fold the drawn $85k into the loan on the office building, which would let the home come off. With the $85k added, the loan would be $1.585M, an LVR of 61.0% on the illustrative $2.6M valuation. Whether to take the home off is your decision, made with the cost of each option in view.
Replacing the air conditioning
Some costs of owning the building fall to the owner rather than the tenant, depending on the lease. Here, the packaged air conditioning units are near the end of their working life, and replacing them is quoted at $180,000.
Effective life is the number of years an asset can be used to produce income, taken from the ATO's determination or worked out by the business. It is a tax figure, not a promise of how long the equipment will run. The determination gives packaged air conditioning units 15 years. Whether the owner or the tenant claims an item is a question for your accountant and the lease.
A refinance can include funds for the replacement, subject to the lender. The worked example includes a path that adds the $180,000 to the loan.
Weighing up the options for the building
Once the loan, the lease and the line of credit are each clear, the options for the building can be set side by side.
Worked example: five paths when interest-only ends
The starting point is the loan switching to principal and interest as planned. Each other path changes the rate, the term, the interest-only period or the amount, and is measured against that starting point.
| Path | Repayment | Against today's path, monthly | Interest over the loan | Against today's path, interest |
|---|---|---|---|---|
| Switch to principal and interest as planned Today | $17,262 | Starting point | $571k | Starting point |
| Refinance to a lower rate, same 120 months | $16,880 | $382 less | $526k | $45k less |
| Refinance over 25 years, principal and interest | $10,794 | $6,468 less | $1,738k | $1,167k more |
| Refinance with five more years of interest-only | $8,750 | $8,512 less | $1,816k | $1,245k more |
| Refinance over 25 years and add $180k for the air conditioning | $12,089 | $5,173 less | $1,947k | $1,376k more |
Illustrative and rounded. Rates are assumptions for the sums, not offers. The line of credit, valuation, legal and establishment fees are left out. The last path borrows $180k more, so its interest is not a like-for-like comparison.
Refinancing over 25 years brings the repayment down to $10,794 a month, which is $1,706 below the $12,500 net rent. That comes at a cost of $1,167k more interest, because the $1.5M is paid back across 300 months rather than 120.
Five more years of interest-only gives the smallest repayment, $8,750. After five years, though, the full $1.5M is still owed, and the repayment then rises to $11,629 for twenty years. It carries the most interest of the first four paths.
The lower rate on its own saves $45k of interest and leaves the term alone. It trims only $382 a month, so the gap between the repayment and the rent stays at $4,380. That shortfall each month is met from the investor's own income.
Adding the cost of the new air conditioning to the loan gives a repayment of $12,089, still $411 below the rent. Borrowing $1.68M is an LVR of 64.6%, inside the full doc limit and just below the bottom of the lease doc range. These figures are not quotes or approvals, and which path suits you depends on the lease, your other income and how long you plan to hold the building.
What secures the new loan
The office building secures the new loan, and some loans have other security alongside it.
- The building alone. Within the LVR limits for full doc and lease doc loans, the office can secure the loan by itself.
- Your home. Keeping the home as security, or adding it, makes the home security for the investment. Taking it off once the building carries the loan alone is your choice. Our step-by-step guide to a commercial property refinance covers each stage and the costs to weigh up.
- Guarantees. Where a company or family trust owns the building, the lender can ask the directors or the trustee's directors for personal guarantees, a personal promise to repay if the owner cannot.
Between tenants, or before a renewal
A change of tenant is part of owning a leased building, and it affects the refinance in a few specific ways.
- A new tenant. A fresh lease restarts the time the rent is promised for. An incentive, such as a rent-free period or a contribution to the tenant's fit-out, lowers the rent in effect, and a valuer can take that into account.
- A signed heads of agreement. A heads of agreement sets out the main terms of a lease that has been agreed but not yet signed in full.
- A vacant building. A lease doc loan rests on the rent, so it needs a tenant paying one. Without a tenant, an application relies on a full doc assessment of your own income.
- A tenant in arrears. Rent arrears or a tenant in financial trouble show in the rent ledger and the bank statements. The finance question is how much of the income can be counted.
Before you apply to refinance the building
The lease, the loan and your own finances each have dates that change what a refinance can do, and a little preparation lines them up.
When to move and when to wait
- A fixed rate. A fixed rate ended before its term can carry a break cost, a fee for ending a fixed rate early. The more rates have fallen since the rate was fixed, the bigger it is. A written payout figure, which states the sum that would settle the loan in full, shows whether the saving outweighs it.
- An option about to be exercised. A lease with its option exercised has more years of rent still to run than one with 18 months left. The tenant decides whether to exercise; the refinance can be timed around that decision.
- A rent review just completed. A higher passing rent can feed into the valuation and the interest cover.
- Your own tax returns. For a full doc application, lodged returns for the last two years show your income beside the rent.
- A loan review on the calendar. The rent reviews in the lease set what the tenant pays, and the lender's review is about the investment loan. It looks at whether the rent still covers the loan and the years remaining on the lease. A review is also a fair moment to see whether another lender may offer more competitive rates. Our guide sets out the checks a lender runs at review time.
What to gather from the lease and the building
- The signed lease, with every variation, the option clause and the rent review terms
- A rent ledger or statement from the managing agent covering the past year
- Outgoings for the building: council and water rates, land tax, insurance and any strata levies
- The current loan statement and a payout figure, plus the line of credit statement
- Quotes for any work the refinance is to fund, such as the air conditioning
- For full doc: your own tax returns and financial statements, or the owning entity's, for two years
- The trust deed or company documents for the entity that holds the title
GST, the goods and services tax, on commercial rent, land tax and the deductibility of interest are your accountant's questions. Interest on a loan used to earn rent may be deductible, and your accountant confirms how that applies to you.
Questions investors ask about refinancing a leased building
What does a 25-year term add in interest?
In the example, refinancing over 25 years at an assumed 7.2% brings the repayment to $10,794, which is $6,468 a month less, and adds $1,167k of interest against switching to principal and interest as planned.
Will the bank lend on the rent alone, or does it need my income?
Either can apply, depending on the lender. Lease doc lending rests on the rent and runs from 65% to 75% of value. Full doc adds your own income and reaches up to 80% on standard commercial property.
The rent no longer covers the repayment. What are my options?
The rate, the term and the interest-only period each move the repayment. In the example, a 25-year term brings it below the rent, at the cost of much more interest.
The rent has gone up since I bought. Can I borrow against the extra value?
You can, subject to the lender. A fresh valuation on the higher passing rent can lift the value.
Can I refinance while the building is empty?
You can apply on a full doc basis, subject to the lender. With no rent to verify, the application rests on your own income.
Is another five years of interest-only possible?
That depends on the lender, the property and the borrower. It keeps the repayment low, but the balance is unchanged when it ends, and the example shows the extra interest.
Can the line of credit on my home be cleared in the refinance?
That is possible, subject to the lender. Folding the drawn balance into the loan on the building can let the home come off, if the building can carry the higher loan on its own.
The air conditioning needs replacing. Can that go into the loan?
It can be added, subject to the lender and the LVR. Quotes for the work set out what the extra borrowing pays for.
Would a lower rate alone close the gap to the rent?
Not in the example. A 6.3% rate over the same 120 months trims $382 a month and saves $45k of interest, leaving the repayment $4,380 above the rent.
We hold the building through a family trust. What changes?
The trustee borrows on the trust's behalf, so the trust deed and trustee documents go in with the application. The trustee's directors may be asked for personal guarantees. Questions about the trust itself are for your accountant.
Talking through your building's loan with us
A leased building is refinanced on the lease it has today, the rent it earns and the dates on both the lease and the loan. Ardent Capital Group can assist with the investment loan on the building, releasing your home from the borrowing and paying for work such as the new air conditioning. Our page on refinancing a tenanted commercial property covers the investment loan in more detail, and finance for a tenanted commercial purchase covers buying the next one. Drawing on a background in financial planning, the Ardent Capital Group team can map out a strategy for the loan alongside your other borrowing, and your accountant confirms the tax side. We would be pleased to look at your lease and your loan together.
