Mortgage for commercial property in the UK

In addition to residential mortgages, there are also products that allow you to obtain financing for commercial properties. These include offices, warehouses, shops and restaurants. The terms of the mortgage and the application process will vary depending on the purpose of the purchase and the borrower’s situation. In this article, we will try to explain how to obtain a mortgage for commercial property in the UK.

What makes commercial mortgages unique?

As mentioned earlier, commercial mortgages are granted for properties intended for commercial use. This means that, just as the condition of a residential mortgage agreement is the obligation to reside in the financed property, in this case the agreement will specify the specific type of activity that will be conducted in the building.

It is also worth knowing that commercial mortgages are not regulated at all by the FCA (Financial Conduct Authority), which gives both parties to the agreement greater flexibility in terms of its conditions. Standard residential mortgagesare subject to strict regulations designed to provide maximum protection for consumers, who are not considered by law to have extensive financial knowledge. This is where the clearly defined requirement for a detailed assessment of affordability and the possibility of seeking assistance from the FOS (Financial Ombudsman Service), the British financial ombudsman, comes from.

In the case of commercial mortgages, the borrower is considered a business entity that has access to professional advice. As a result, each agreement can be approached on a more individual basis, using more non-standard terms tailored to the specific needs of a given business or investment.

Please note that when deciding to invest in property through a Buy-to-Let or Holiday-Let mortgage, you must take into account the costs of legal advice.

Types of commercial mortgages

Commercial mortgages are generally divided into two subtypes:

• **Owner-Occupier Mortgage **– this type of commercial mortgage is intended for situations where the borrower will also be the entity operating in the financed property. An example would be the purchase of an office by an accounting firm.

• **Commercial Buy to Let Mortgage **– in this case, the borrower purchases a property with the intention of renting it out later and generating a return on the investment.

This division of commercial mortgages may be somewhat reminiscent of the division of residential mortgages into the most popular residential mortgages andBuy to Let mortgages (not all of which are regulated by the FCA). Although all these products differ from each other, certain similarities can be seen in the classification, particularly in terms of the approach to creditworthiness. Namely, in the case of Owner-Occupier Mortgages, the company’s financial results are taken into account, as is the case with residential mortgages, where the individual creditworthiness of the customer is assessed. On the other hand, commercial investment mortgages look at the expected return on investment, as is the case with traditional Buy to Let mortgages.

Creditworthiness assessment for Owner-Occupier Mortgages

Due to the limited regulation by the FCA, banks have considerable discretion when it comes to assessing the creditworthiness of a company applying for a mortgage. The procedures used by banks are designed to check the financial situation and operational capacity of the company, enabling them to assess the risk associated with granting financing.

The most important indicator usually used by banks in such situations is EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation), i.e. the company’s profits before deductions:

• financing costs – interest related to the repayment of previously incurred debts;

• taxes;

• depreciation – non-monetary costs related to the wear and tear of fixed assets (e.g. machinery, vehicles, buildings).

EBITDA shows the actual profit generated by a company, eliminating factors specific to each company, such as debt levels, tax burdens and accounting methods. However, it is often the case that bank analysts adjust a company’s profit by adding various expenses, such as directors’ benefits, in order to obtain a more realistic picture of the company’s financial situation.

EBITDA is strongly linked to another indicator – DSCR (Debt Service Coverage Ratio). It shows the ratio between EBITDA and debt service, i.e. the annual cost of credit. For example, if the total amount of monthly instalments in one year is 20,000 and EBITDA is 24,000, the DSCR will be 120%. The required DSCR values vary, but in simplified terms they are as follows:

• 120% to 125% - For very stable companies that fall into the low-risk sector;

• 135% to 150% - For most companies that have an established position in the market;

• Over 160% - For companies in the high-risk sector or for mortgages with a high LTV ratio.

In addition to analysing the EBITDA ratio, bank employees conduct a detailed financial assessment of the company. To do this, they need detailed insight into the company’s finances, specifically factors such as:

• Financial history – in order to analyse this, banks require the company’s financial and management reports for at least the last 2-3 years;

• The sector in which the company operates and its business plan – for example, if a company needs real estate to open a restaurant, the bank will conduct a risk analysis based on specific data such as budget, location and the success of similar businesses in the area.

• The credit history of the company and its owners and managers;

• The experience of the owners.

Can such a mortgage be granted to a private individual?

An Owner-Occupier Mortgage can be granted to a private individual who operates as a Sole Trader. In this case, the process is much less complex, as the bank has far fewer tools at its disposal to assess the customer’s creditworthiness. In this case, the analysis process is limited only to their personal financial situation, as they are self-employed and operate on their own behalf. However, this does not mean that the analysis is less detailed – the bank will always make every effort to ensure that its estimates are as reliable as possible.

This situation may resemble taking out a standard mortgage, but it is important to remember that due to the purpose of the property, the risk is automatically higher. This translates into much less attractive terms and conditions for the same customer creditworthiness. While a mortgage can be taken out with a 5% or 10% deposit and still have a relatively low interest rate, an Owner-Occupier Mortgage will require a much lower LTV and the interest rate will be higher – the required deposit will often exceed 25% of the property value.

Commercial Buy to Let Mortgage

The credit assessment for a commercial investment mortgage is not very different from that for a standard Buy to Let mortgage. It also focuses more on the profitability of the investment than on the borrower’s financial situation. The differences lie in the level of detail of the overall assessment – in the case of commercial mortgages, a full business analysis will be carried out, very similar to that described above for Owner-Occupier Mortgages.

The main difference is the different functioning of the DSCR ratio – in the case of a commercial BTL mortgage, the factor covering debt servicing is the expected rental income, not the company’s income. It is this value that will later determine the success of the stress test. To make it easier for the bank to decide to grant a mortgage, it is a good idea to find a tenant before purchasing the property. This solution allows the analyst to see that the rental income is guaranteed or almost certain. There are two ways to do this.

The first and most desirable option is, of course, to sign a lease agreement before purchasing the property (pre-let). In this case, the bank has a guarantee that the property will not stand empty from day one and that the rent will cover the mortgage servicing from the outset. Pre-let agreements are usually structured in such a way as to protect both parties from the risk that the financing will not go through. This may be a condition of validity (conditional agreement) or a detailed credit clause (Mortgage Clause), which specifies the deadline for obtaining the mortgage and who bears the costs if the mortgage is not granted.

Another option is to obtain a letter of intent (Heads of Terms). Although this does not give the bank a 100% guarantee that a lease agreement will be concluded immediately, in the eyes of the financial institution it is a very good sign that there is real interest in the premises and a potential tenant. Such a letter is a preliminary and non-binding agreement between both parties, which sets out the terms of the future agreement.

Summary

Mortgages for commercial properties are a completely different group of products. Although purchasing a property for business purposes is a more complicated process, if you decide to work with a reputable mortgage broker in the UK and a good conveyancer, you will certainly be able to realise your plans. We cordially invite you to work with us – we will be happy to help you at every stage of buying property in the UK. Please note, however, that Extend Finance Ltd is not authorised to provide advice on business mortgages; such matters will be referred to external parties.