Robin Lockhart-Ross, Head of Risk at Nedbank Corporate Property Finance shares his thoughts on this important topic of debate which has again surfaced in the industry more recently: 

Recently, questions have once again been raised about the logic behind shorter repayment periods generally granted by finance institutions on commercial property loans in comparison to the 20 to 30 year loan terms that are the norm for residential home loans:

It may seem odd to many observers that banks generally limit the length of their commercial property loan repayment periods,as this means they are losing out on years of potential interest earnings. However, to understand the reticence by banks to offer longer-term commercial property loans, one must look more closely at the complexities of this credit environment.

While the credit approval decision for a residential home loan is generally based on the relatively straightforward criteria of affordability, credit record, and historical property value, commercial property finance is usually significantly more complicated.

Whilst Robin can’t speak for all banks and lending institutions, for Nedbank Corporate Property Finance, the perceived security of the cashflow likely to be generated by the leases over a commercial property plays a vital part in our determination of the nature, amount, and term of the finance that they offer.

This means that the commercial property loan is structured primarily around their assessment of the likely sustainable cashflow that will emanate from the property. There are two key factors that influence this assessment:  The first is the security and length of the leases that exist or are being negotiated with tenants; and the second is the financial substance and credit rating of those tenants.

This approach means there are no hard and fast rules regarding the terms of finance Nedbank Corporate Property Finance will grant. Each application is assessed on its individual merit. When an applicant is able to provide proof of a solid tenant, with a long-term lease (including whether there are any escape or exit clauses for the tenant) the likelihood of a longer loan period of at least 10 years, but possibly more, is good.

However, there are other factors that banks have to consider, in addition to tenant cashflow, before deciding on the term of a commercial property loan they approve. The introduction of Basel II (and Basel III in the near future) has meant that longer-term commercial property funding now costs the finance provider more due to the regulatory requirements concerning the capital that must be held against the long-term assets. In property finance, ‘liquidity premiums’ are levied, which can become very costly on longer dated loans, unless they can be passed on to the client in the form of higher interest rates – which is a less than ideal situation for either party to the loan transaction.

In recent years, the historical trend towards higher interest rates on commercial loans compared to those of residential loans has been all but reversed, with many commercial property financiers granting loans priced at prime rate or better. If these finance providers were to now opt to pass on liquidity premium costs to their clients in the form of higher interest rates, their competitiveness in the market would be severely undermined. So the more viable solution is to reduce their capital costs and, consequently, the interest costs of their clients, by limiting the term of the loan.

Another factor to bear in mind is the fact that commercial property finance is generally granted on the basis of the borrower, property and tenant as they exist at the time of the loan application. The nature of the commercial loan means that the credit provider is effectively locking itself into the pricing, margins and risks for the full duration of the loan term. This can have profoundly negative consequences in the case of a long-term loan because the financier is unable to amend the pricing in line with changes to the market or borrower circumstances.
 
A shorter loan, with renewal options or a so-called ‘bullet payment’, gives the commercial property financier the scope to revisit the initial pricing more regularly – for example, on a five year loan when it expires and comes up for settlement or refinancing, and to re-price the deal if circumstances have changed adversely since the original advance in year one.

Another concern that is regularly raised by commercial property market stakeholders is the perception that banks shy away from longer term loans due to the maintenance requirements of such properties over the longer term. While the assessed maintenance requirements of a property certainly play a part in overall loan decision, Nedbank Corporate Property Finance would consider this purely in the context of the impact such maintenance or refurbishment costs may have on the cashflow generation of the building. Only if excessive maintenance was deemed to have the potential to limit long-term cashflow would it directly influence the term granted on the loan.

So, while it may appear that banks simply follow a blanket approach for limiting the terms of many of their commercial property loans, the opposite is true. In many ways, the tendency to keep such loan repayment periods shorter is beneficial to all the parties concerned – protecting the business interests of the lending institution itself, while increasing the chances of the loan being approved and, ultimately, limiting the costs for the borrower.