Why LTVs are (almost) irrelevant in Commercial Property Investment.

The appetite of Commercial Property lenders has been rapidly shifting since the Bank of England began increasing interest rates in December 2021. Increasing the rate to a 15-year high from 0.10% in March 2020 to 5.25% in August 2023.

As a result of this, the way we approach Commercial Property transactions has altered.

Previously, asset values and a lender’s leverage metrics were at the forefront of the underwriting process, with the most frequent question from investors being – “Which lender can offer the highest LTV against this site?”

These days a borrower’s attention should be shifted toward the rental income of a property, the standing of the tenant and achievable lease terms, as these points are likely to cap a lender’s LTV before any maximum leverage limit is reached.

Therefore, let’s remind ourselves of the key areas lenders examine to determine a client’s ability to service Commercial Property Investment debt, and if your next deal ‘stacks up’.

We start with the main debt servicing figure (ICR), and then drill down to how this is amended and caveated by various lenders:

Commercial Property: Interest Cover Ratio (“ICR”)
Commercial Property: Interest Cover Ratio (“ICR”)

Commercial Property: Interest Cover Ratio (“ICR”)

Most lenders expect the annual rental income of a property to cover 125% to 145% of the lender’s annual interest and capital repayments, i.e., if your annual payments are £100,000, the property will need to generate £125,000 in rental income. This gives the lender comfort that the borrower has a 25% headroom in their income to service debt. Nonetheless, various lenders will tinker with these numbers and apply some extra caveats when they are assessing rental income and their anticipated repayment figures, which we cover below:

Stress Testing with Commercial Property

The first hurdle your rental income and ICR ratio must beat is the lender’s stress test. Lenders will stress test your loan a higher interest rate than the rate offered or your agreed ‘Pay Rate’ (the rate that has been offered), whichever is the higher.  We see the Pay Rate used frequently for interest-only and fixed-rate mortgages. For mortgages on a variable rate, these are usually stressed at the Lender’s Margin + Base (or Sonia) + an additional 1-3% (depending on the lender’s risk appetite). So even if the lender has quoted you a rate of 7% (including their margin and base), they may be stress testing your rental income against a theoretical 10%, as opposed to 7%, to see if their 125% Interest Cover Ratio is still met in a higher interest rate environment.

Gross to Net Rent Deduction for Commercial Property:

Typically, your gross rental income isn’t the income a lender will use, as they will apply a ‘Gross to Net Rent Deduction’ anywhere from 5% to 20% depending on several factors, such as:

  • Property Management: If the property is managed by an agent, their fees must be deducted from the gross rent.
    • Lease Types: If tenants are on Internal Repairing and Insuring Leases (IRI), where they typically have a narrower liability for repairs than tenants on Full Repairing and Insuring Leases (FRI), lenders may apply a higher percentage deduction to the gross rent to cover potential repair costs.
    • Utilities and other costs: If the investor incurs any additional costs for leasing the property, these may also be factored in.

Lease Breaks, Lease Expiry Dates & WAULT:

Commercial Property is not as easily lettable as residential property; therefore, void periods can be significant and cause a substantial reduction in income should a tenant decide to vacate. As a result, lenders may review the Weighted Average Unexpired Lease Term (WAULT) when assessing a client’s ability to service debt over a five-year term, for example. WAULT acts as an indicator of the average remaining life of leases related to a specific commercial property if it is let to multiple tenants or an entire commercial property portfolio. Therefore, if your commercial property has five tenants, and all their leases have break clauses coming up in the next year, this may not be viewed favourably by a lender…

Covenant Strength:

Even after the lender has plugged all these different metrics into their model to assess if they think your income will be enough to service their debt over the term of their loan, their assessment can very much start and end at the simple question of, “who is the tenant, and do they have the financial ability to pay your lease?”

  • Are they profitable?
    • What is the Net Asset position on their balance sheet, do they have any significant liabilities that could impact their ability to pay a lease?
    • What industry is the tenant in? Some lenders may not be keen on tenants in specific sectors that they deem to be risky.
    • What is their Credit Rating, have they had any recent CCJs lodged against them?

To summarise, with the base rate being at a 15-year high, many commercial property investors will need to consider if a potential investment can service higher debt costs when assessing fundability, rather than assuming that because a lender will lend a maximum 75% LTV against commercial property, this is what they’ll be able to lend against a specific transaction. Fresh Thinking Advisory is a boutique funding consultancy that offers premium advisory services for trading and property businesses.