Residential, Rural and Commercial / Industrial Properties – What’s the difference?
Well quite a bit of difference in fact. Mortgage lenders are concerned about many things, but arguably the most important issue for a lender is ‘credit risk’.
When any lender looks at a borrower, whether they be an individual, a partnership, a company or even a trustee, they are looking to understand and identify whether the applicant is a ‘good’ credit risk’ for the money they will lend.
To understand credit risk, lenders look at three key areas. Of course there are many other factors to consider, but these are the three major ‘risk’ issues for mortgage lenders.
- How to confirm the level and source of a borrowers income
- Identifying past credit records (i.e. credit history) and
- The property security available to protect the lender against payment default
Income and credit history are items that can be verified, but of course, borrower income and future credit repayment conduct can never be guaranteed in advance.
Borrowers can lose jobs, businesses can fail and marriages can and do break-up; so as far a lender is concerned, the one reasonably constant factor in the ‘risk’ equation is the ‘value’ of the property security available.
So, if the unthinkable happens and a borrower defaults on a mortgage loan, the lender (the mortgagee) has the right to ‘seize’ the property from the mortgagor (the borrower) under the terms of the loan contract, if the borrower defaults on the agreement.
Of course, a lender must follow certain procedures before a property is seized and dependant on the nature and type of loan, the borrower may have some recourse to amend the terms of the loan contract to assist under certain circumstances.
However, in the final analysis, if a borrower defaults on a loan and a loan contract allows the lender to secure the property, as night follows day, this will happen.
Now, lenders all have their own credit policies when it comes to what types of properties they will accept as security. For one lender, a small industrial unit is quite acceptable as security for a mortgage loan, but for another they won’t accept it at all.
Strange you may think, but there are many reasons as to why lenders do what they do!
Some of those reasons may include:
- A lack of ‘credit assessment’ expertise in that type of property security
- A business decision to exclude any or most property types
- Funding sources not willing to lend against various security types
- Lender perception of an unacceptable risk
...and many other reasons.
So what are the key differences in how credit officers of lending institutions view different classes of property for security purposes?
Residential Properties
Clearly, residential property is the mainstay of mortgage lending in Australia. There are many more residential properties available to secure, than any other property type, and for this reason alone, most lenders are happy enough to secure loans against residential property
Why?
- Easy to value (with solid comparable sales values available)
- Can be income producing (rental)
- Property values generally hold well over time
- Steady price growth over time
- A steady buyer market in relative terms
- Borrower default protection insurance available (Lenders Mortgage Insurance)
So for a lender, by securing a loan against residential property, their ‘credit’ risk is reduced significantly. Unless a residential property is significantly damaged, is located in a risk area (flood prone etc) or in fact is in an economically depressed geographical region, then a lender is often adequately protected against borrower repayment default.
This is why, most lenders in Australia ‘love’ residential property to have as security against a loan. But residential property is not ‘homogenous’ by nature.
What this means is;
If a lender is offered two residential properties for security purposes and both have been built by the same builder, to the exact same specifications, on blocks of land that are identical in dimension, then maybe you could assume that their relative ‘security’ value would be fairly close.
Well that depends on one big factor and that factor is where they are located. If one property is located in the suburbs of a capital city and the other is located in a small country town, then of course, the values will differ. This isn’t rocket science. But the lender is also looking at the likely time it will take to sell the property in the event of default.
The suburban property ‘should’ sell reasonably quickly given it has been sold in an orderly fashion and on a ‘willing seller and buyer’ terms. That is, not a 'firesale' or an ‘advertised’ mortgagee auction.
The country property may take an extended period of time to sell and may also sell at a heavy ‘price’ discount due to the lack of a ‘deep’ buyer market.
What does this mean to the lender at the time of actually lending the money; well the lender may decide to only lend 80% against the value of the ‘country’ property, whereas a lender may feel very comfortable to lend up to 100% of the suburban residential property value, with Lenders Mortgage Insurance attached.
Ultimately though, if you want to buy or refinance a residential property, you should expect very competitive interest rates to apply, compared to other types of property classes.
Mortgage lenders who still charge an interest rate premium based on the purpose of the loan, (e.g. business working capital requirements), are being weeded out commercially, so more and more lenders are ensuring that for ‘business purpose’ loans secured against residential property, residential rates should apply.
But some lenders still try that little trick. Particularly the business banking divisions of the major banks! Beware!
Rural Properties
Why do so many lenders avoid rural properties as security for loans?
Well the most important reason for lenders is that unlike residential properties, rural property values can be directly affected by not only ‘external’ economic factors, but climatic conditions as well.
In simple terms, a rural property that produces wheat that is also in the grip of extended drought conditions will clearly be less valuable than a rural property producing ‘bumper’ crops with solid market demand for their produce.
And who knows when it will rain or not?
What ‘day to day’ lender knows what the impact on Australian rural property values will be, in the event of another country deciding to heavily subsidise its own farmers produce.
Now, lenders are not farmers. Their aim is to understand risk and for those specialist rural lenders, who do in fact understand agribusiness risk, they will assess the rural property in conjunction with the activities of the farm accordingly.
So many ‘other’ lenders are now venturing into rural property lending, but only in a limited capacity. Remember, their expertise is not agribusiness.
Based on their understanding of the risk factors involved, some lenders are now ‘picking the eyes’ out of the rural property market.
For some ‘non agribusiness lenders’, a proposed rural property is valued without considering any business or agricultural ‘value’ at all; just real property value.
What must be recognised with rural properties is that there are many ‘risk’ factors that residential lenders do not want to consider.
We now have a number of private funding specialists that will lend against the basic real property’ value of rural proprieties, thus providing real alternatives to borrowers looking to secure funds against their ‘rural’ non farming property.
Finally, rural properties can also be broken down into a few sectors. Some properties types are acceptable to non ‘agribusiness lenders’ but many are not;
Properties for consideration for ‘non agribusiness’ lending
- 5 acre semi rural / rural ‘lifestyle properties
- Rural properties - less than 100 acres with very limited or no agricultural activities
- Rural properties – owner occupied dwelling – no agribusiness < 100 acres
- Rural acreages looking to subdivide for residential or semi rural lifestyle developments
- Some rural properties and borrower income derived from non agribusiness activities
In simple terms, if the property is a farm, an agribusiness lender will be necessary. An agribusiness lender will require balance sheets, profit and loss statements, tax assessments and tax returns and they will want to understand the activities of the farm, not just the real property value. Agribusiness lenders do not offer ‘plain vanilla’ type home loan rates and conditions. It just won’t happen that way!
However, if the rural property doesn’t provide an income, or is deemed to be ‘marketable’ as per the credit policies of the nominated lender, then there is a strong chance of you securing residential rates on a mortgage loan, but usually at a reduced, loan to value ratio. This just means they won’t lend say 80% of the value of the property; they may only lend up to say 65% of the value.
But that depends on which lender you’re talking to.
Commercial / Industrial Properties
Commercial and Industrial properties are generally the least understood property types as far as their security value is concerned.
Clearly commercial and industrial properties are designed for income producing activities and not much else. Many properties in this class are purpose built for both owner occupiers and or investors.
Lenders, who allow these types of properties as security, will look at a number of factors to assess their risk position.
- Location of the security
- Facilities of the property
- Comparable sales evidence
- Market rents
- Business fundamentals and financial strength of the applicant
- Applicant expertise in the industry type
- Equity in the property
- Applicants credit profile
Historically, lenders have assessed the strength of the business by way of an intensive appraisal of all business and financial statements, particularly for owner occupiers of commercial or industrial properties.
In more recent times, some relaxation to these requirements is in evidence, with some lenders prepared to offer limited’ low documentation loans secured by ‘some’ commercial or light industrial properties.
This simply means some lenders will allow borrowers to ‘self certify’ their income position due to limited financials being available at the time. Other lenders will request less onerous income verification by way of recent ‘MYOB’ statements and BAS returns as indicators of business income.
Commercial and Industrial properties values, similarly to farms, are directly correlated to the business activity and the relative success of both the individual business, and the ‘health’ of the industry that it participates.
Business banking lenders have historically handled (and still do) commercial and industrial securities, as they are obviously tied up with the associated business ventures, however, for borrowers who do not fit into the credit standards of business banks, there are more and more flexible credit policies becoming apparent. In fact, some commercial lenders are positioning their credit policies and procedures, much like residential lenders, but with non residential securities. Good news for all small business people
For the small businessperson with a light industrial unit or commercial property available for security, so long as there is adequate ‘equity’ (ownership) in the property, a mortgage loan may be made available, with significantly less initial and ongoing credit requirements usually demanded by business banks.
Lending standards will still be maintained, but due to a greater understanding and the recognised price stability for commercial and industrials for the small to moderate borrower, greater loan product opportunities are now in evidence.