Frank vs the Large Corporation

Common thinking might suggest that the lower the LVR on a loan the lower the risk. However does a low LVR loan offer the best likelihood of reliable interest payments and the return of capital? Consider for instance a low LVR loan (say 50% of property value), which is leased to “Frank the Butcher” for a 5 year period. Let’s compare this loan to a 70% LVR loan where the tenant is a substantial public company or government agency. Which loan exhibits the lower risk? While the LVR exposure to Frank is considerably lower, an investor needs to consider what happens if Frank goes broke or leaves? Can a replacement tenant be found, will substantial modifications need to be made to the property (e.g. the cool-room removed or refurbishments completed) to obtain a new tenant? Will a new tenant pay a higher or lower rent and will a large lease incentive payment be required? If the rent is lower, what affect will that have on the value of the property and hence the LVR.

The higher LVR loan however while having a much higher percentage lend against the value of the property is underpinned through the value of the asset being supported by the income stream which is in turn supported by a long term lease to a high quality (credit rated) public company or government agency. Accordingly while at first glance the lower LVR loan to Frank appears safer, the reality is that the higher LVR loan with income from a higher quality tenant is likely to present the lower overall risk.

That is not to say that either the loan to Frank or the loan to the public company will face issues but it does illustrate the need to look behind the obvious issues of LVR and DSCR and consider underlying issues such as market demand, tenancy demand, market rents and the borrowers capacity to correct issues if something goes wrong.