While possibly best known in the residential market, the benefits of gearing are equally valuable in the commercial property sphere.
"The first thing you need to understand is that financing for commercial property is subject to much more stringent requirements, and tends to be less comprehensive than financing for residential property," says Jason Gregoriades, a member of the Rawson Property Group's commercial team.
"This directly affects both the gearing potential of commercial properties, and the approach prospective investors need to take. It does not, however, mean gearing commercial property is not a potentially profitable avenue."
Commercial loans generally cover a maximum of 70% of the purchase price (excluding any and all VAT), requiring a 30% to 35% deposit by the purchaser. This limits commercial gearing potential to 70%, as opposed to residential properties that can often be geared as high as 90%. "The lower gearing potential isn't necessarily a bad thing, however," Gregoriades points out, "as it limits the risk of the investment, not only for the bank, but also for the investor."
With a typical maximum loan term of only ten years, investors will also find the monthly repayments on a commercial loan far higher than those on an equivalent residential loan. "Commercial property is, by its very nature, an income generating asset and, as such, banks do have higher expectations when it comes to paying off loans faster," he explains.
Interestingly, banks not only offer comparatively short loan terms, but also tend to insist that the net income of the property equal or exceed the cost of the repayments each month. For the investor, this type of situation (where the property's income covers all of its expenses and financing) is known as positive gearing, and once again reduces the risk of the investment for all parties involved.
"Ideally, a commercial property should be able to pay itself off completely by the end of its loan term, requiring no financial input from the investor aside from the initial capital outlay. This does, however, require stable and preferably long-term tenants, and securing these should be high on the investor's priority list during their due diligence process."
While positive gearing doesn't have the same tax-reducing potential for portfolios as negative gearing does, commercial property loans do have some tax benefits of their own. "All interest accrued on a commercial property loan qualifies as a business expense and is therefore tax-deductible," says Gregoriades.
"This can make a worthwhile dent in a business's tax burden, and is the reason we almost always recommend commercial property investors gear their purchases to some extent. In cases where a business or portfolio is able to buy the property outright, with cash, we still suggest a loan of at least 30% in order to take advantage of the tax break - the savings typically outweigh the cost of the financing, making it an easy win."
Easy may not be a term you otherwise associate with commercial property gearing, but the detailed documentation and due diligence required to secure financing does help reduce the risk of the investment. Nonetheless, Gregoriades advises approaching commercial gearing conservatively in the current financial climate, as tenants are coming under pressure which will inevitably filter down to commercial property owners.
"There are many benefits to gearing, but gearing too much is always risky, especially when the economy is under pressure. Do your homework, and don't rely on the bank to decide whether a property has the potential for success or not. You need to be 100% confident in your investment before you put pen to paper," Gregoriades concludes.
