Scenario: a business buying commercial property

This page follows a hypothetical engineering services firm buying a small commercial building. The firm, the property and its tenants are invented to show how lenders and advisers generally approach a purchase like this. Where numbers matter, the linked Privet tools let you enter your own.

The purchase

The hypothetical firm has outgrown its rented office. A two-level building near its current premises has come up for sale. The ground floor is let to a pharmacy on a lease with a few years to run, and the upper floor is vacant, which the firm plans to occupy itself. Owning the building would give the firm control over its premises and rental income from the pharmacy to help meet loan costs.

The firm's directors plan to buy through a new company and fund the purchase with a commercial property loan, contributing the balance from retained profits. They have not bought commercial property before, so they want to understand how a lender will view the deal.

How a commercial lender looks at the building

Commercial lending is less formulaic than home lending. Lenders typically consider the value of the property from a valuer they instruct, the quality of the income, and the borrower's own financial position, then set limits on the loan relative to value and to income.

The leases

For a part-tenanted building, the lease documents are central. A lender will usually ask for copies and look at:

• The remaining term and any options the tenant can exercise to renew.
• How and when rent is reviewed, for example fixed increases or market reviews.
• Which outgoings the tenant pays and which fall on the owner.
• Any incentives, rent-free periods or rights to terminate early.
• The tenant's own financial strength, sometimes described as the tenant covenant.

A valuer will also consider whether the rent is in line with the market. Rent well above market may not be sustainable at the next review.

WALE

WALE, or weighted average lease expiry, condenses the lease profile into a single measure of how long the current income is contracted to run. In this example, there is one tenant on part of the building, so the WALE is simply that lease's remaining term, and the firm's own occupation of the upper floor is assessed separately. On larger properties with several tenants, lenders weight each lease by income or area. A shorter WALE generally means the lender sees more risk of vacancy and may respond with a lower loan amount or a shorter term.

Interest cover

The interest cover ratio compares the property's net operating income, meaning rent less the owner's outgoings, with the annual interest on the loan. Lenders set their own minimum ratio, and many test it at an interest rate above the current one.

Because the firm will occupy part of the building, a lender may also look at the firm's profit and its capacity to pay what amounts to rent for its own space. The interest cover calculator lets you enter the expected rent, outgoings, loan amount and interest rate and see the ratio, then test it with a vacancy or a higher rate. The ratios lesson explains how interest cover differs from debt service cover.

Yield

Investors and valuers often describe commercial property by its yield, the rent as a share of the price. Entering the asking price, rent and outgoings in the rental yield calculator shows the gross and net yield on your own figures and helps put the price in context against similar properties.

GST: is it a going concern?

Commercial property sales are generally subject to GST. However, the sale of a leased property can be GST-free as the supply of a going concern when the conditions are met. Broadly, both parties must be registered for GST, the seller must supply everything needed to continue the enterprise, the seller must carry on that enterprise until the day of supply, and the parties must agree in writing that the sale is of a going concern. The ATO explains this on its selling a going concern page.

This building is only partly leased, and the buyer plans to occupy the vacant floor. That may change whether, or how much of, the sale can be treated as a going concern. If GST does apply, the firm will generally need to fund it at settlement and claim it back as an input tax credit later, which can be a short-term cash need in its own right. This is a point for the firm's accountant and lawyer before contracts are signed.

Transfer duty by state

Transfer duty is payable under the rules of the state or territory where the property sits, and commercial property is not treated the same way everywhere. Some jurisdictions have changed or are changing how commercial property is taxed on transfer. In the ACT, for example, commercial conveyances below $2,100,000^[1] are generally not subject to conveyance duty. Elsewhere, standard duty scales generally apply.

The stamp duty estimator gives an estimate from the published schedule, which the firm adds to legal, valuation and loan costs. If the firm bought shares in a company or units in a trust that owns the building, rather than the building itself, landholder duty rules could apply instead. The stamp duty and land tax lesson covers the differences, and land tax will be an ongoing cost of ownership.

What can go wrong

• The tenant leaves. If the pharmacy does not renew, income falls and interest cover weakens.
• Valuation below price. The lender lends against its valuation, which may leave a larger contribution to fund.
• GST treatment is misjudged. An unexpected GST bill at settlement can create a cash shortfall.
• The firm's trading dips. With the firm as an occupier, a weaker year affects both the business and the loan.

Questions to ask

1. How will each lender assess the leases, the vacancy and the firm's own occupation?
2. What minimum interest cover applies, and at what assumed rate?
3. Does the sale qualify as a going concern, and what happens if it does not?
4. What duty applies in this state, and are there any concessions or recent changes?
5. Which entity should own the property? Ask an accountant and lawyer.

For more on commercial borrowing, see the commercial property hub. This scenario is general information only and not financial, legal or tax advice.