How do Lease Doc Loans work?

A common question we get from new investors is how do lease doc loans work? Here we attempt to answer that question with a worked example.

What is a lease doc loan? In simple words a lease doc loan is a loan where the primary information needed by the lender is the lease, and they rely on the strength of the lease to determine whether they will provide lending. In most instances the loan is only provided to a company or a trust, not to individual borrowers.

Advantages: The biggest advantage of these types of loans is that they don't rely on the borrower’s income, and so there is no need to provide such information. So if the investor happens to be unemployed, or self-employed with low reportable income, then this approach can still work provided the property’s income is sufficient.

An example of a lease doc loan provided by one of the big 4 lenders in 2023 is as follows:

  • Maximum Loan to Value Ratio of 65%
  • They require an interest cover ratio of 1.5 times
  • They will assess the interest expense at a hurdle of the current interest rate + 0.5%
  • In assessing the rent they will discount the net rent by 5% for other property related costs that the owner may incur

Consider the example of a new purchase of commercial property at a price of $1M with a net yield of 7%:

  • Property Valuation: $1.0M
  • Rent: $70,000 p.a.
  • Current yield = 7.0%
  • Approved Interest rate of 6.5%
  • Maximum Loan amount = 65% x $1.0M = $650,000
  • Assessed Interest Expense: $650,000 x (6.5%+0.5%) = $45,500
  • Factored Rent = $70,000 x 0.95 = $66,500
  • Interest Cover Ratio = $66,500 / $45,500 = 1.46 (which is just less than the required ratio of 1.5 implying the maximum loan amount is marginally less than $650k)

To illustrate this graphically we have determined the maximum loan amount for a new commercial property purchase at yields varying between 3% and 9% adopting both today’s current interest rates of ~ 6.5% and those of ~ 12 months ago (~3.5%).  For the lower interest rate scenario we have also used a higher interest rate buffer of 1.5% which was more representative when rates were lower. Noting that these buffer margins do change, and the lower value of 0.5% now reflects the belief that interest rates are nearing the peak for this cycle.

It can be seen that prior to the recent rate hikes a 4.7% yielding property could service a 65% loan without having to rely on the borrower’s income. Today, with much higher interest rates the property needs to have a ~ 7.2% yield to borrow the same amount.

Disadvantages: This also illustrates one of the primary disadvantages of these types of loans which is that the term of the loan is generally linked to the lease term so when the lease expires the loan will be reviewed. In this instance if the property was only purchased one year ago and the lease expires this year without much rent growth then it is possible that the borrower would have to contribute more equity to reduce the LVR to within the lender's limits.