If you operate in the commercial mortgage market, you have probably found yourself casting an envious eye at your residential market peers over the past few months.
While mortgage rates soared after the Bank of England (BoE) started increasing interest rates in December 2021, things have eased of late, thanks to falling swap rates.
Borrowers are still grappling with higher borrowing costs, of course. But, at the time of writing, there are 27 lenders offering sub-5% mortgage rates — with more being added daily, according to data firm Moneyfactscompare.co.uk.
Until rates come down, the sector will bumble on
That is a far cry from a couple of months ago, when most rates started with a ‘6’.
Why, then, do commercial mortgage rates remain stubbornly high?
First, there are many more lenders in the residential market, which creates intense competition. That alone helps keep mortgage rates down in that sector.
But another key reason is the make-up of the commercial mortgage market itself.
In the residential mortgage market, you have a good mixture of lenders with a variety of funding sources. You’ve got building societies, which are reliant on savings deposits; non-bank lenders, which tap the wholesale markets for funding; challenger banks, which use a mix of the two; and, of course, the big banks, which have deep and varied pools of capital to call upon.
What does that mean? In theory it means that, if one funding channel becomes less viable, you have another type of lender with a different funding stream ready to step in and pick up the slack.
If the predictions are correct and rates start to fall by next summer — or even earlier — I believe activity will ramp up quickly
The commercial mortgage market, on the other hand, is dominated by challenger banks that have very similar sources of funding.
That’s not a dig at challenger banks. The ones we deal with are professional, know the commercial market inside out and are committed to the sector. But there are some drawbacks when a market is dominated by a few lenders with similar funding profiles.
Reliant on savings
The issue is that, while challenger banks can and do tap the wholesale markets for funding, they can’t do so on the same terms as the big banks. That means they are more reliant on savings to fund their loans and, as a result, are less affected by movements in swap rates.
It’s hard to envisage commercial rates going the same way as residential as things stand, due to the way the commercial mortgage market is structured
As we have seen over the past 20 months, savings rates have rocketed and hence challenger banks’ funding costs have risen significantly. And, to protect their margins, they have been forced to keep their rates higher.
It’s worth noting too that commercial mortgages are 100% risk weighted, meaning that the cost of capital is higher.
That causes a problem because many borrowers don’t want to commit at a time when commercial mortgage rates are around 8% to 9%.
At the same time, they see rates coming down in the residential mortgage market and assume it’s only a matter of time before the same happens in the commercial sector.
Therefore many are biding their time, waiting for commercial mortgage rates to follow suit, which is hampering lending volumes.
The commercial mortgage market is dominated by challenger banks that have very similar sources of funding
However, as I outlined above, it’s hard to envisage commercial rates going the same way as residential as things stand, due to the way the commercial mortgage market is structured.
Domino effect
The question is: what needs to change to inject a bit of life back into the commercial mortgage market?
In short, interest rates need to fall. Should that happen, it would feed in to lower savings rates, which would in turn result in cheaper funding for challenger banks and, theoretically, lower commercial mortgage rates.
The good news is that this may not be as far away as we think. BoE governor Andrew Bailey insists it is too early to start talking about rate cuts, but others seem to disagree.
Just last month, BoE chief economist Huw Pill said market predictions of a first rate cut next August were not “totally unreasonable”.
Economists at Goldman Sachs, the investment bank, believe the first cut may even appear in the first quarter of 2024 if we fall into recession.
There are many more lenders in the residential market, which creates intense competition
Until interest rates do come down, I imagine the commercial mortgage market will bumble on as it has done for the past six months.
But, if the predictions are correct and rates do start to fall by next summer — or even earlier — I believe activity will ramp up quickly.
That’s something to look forward to.
Lucy Waters (née Barrett) is managing director of specialist finance broker Aria Finance
This article featured in the December 2023/January 2024 edition of MS.
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What an insightful article. Thank you.
A couple of observations
1. Commercial lending market, especially portfolio BTL in the region of £5m – £25m is devoid of any real choice. This ought not to be the case since this space in the USA is fairly crowded and capital markets cannot get enough of securitising wholesale loans to fund this segment. The mid-sized insurance companies and pension funds too had a busy few years in the USA where loans were typically offered at 200-300 basis points above that of 6-month treasury swap rate. UK banks have very little appetite especially as you rightly mentioned the assigned Risk Weighted Assets (RWA) of 100%. There is merit in academic discussion around this RWA classification but this is for another time. With the advent of Private credit funds, the enormous dry powder, I envisage an opportunity for non-banking institutions to fill this void.
2. The challenger bank syndrome – after the FCA fined a particular challenger bank for misreporting or rather mis-assigning RWA to their loan book(s), a number of similar banks have retreated with their appetite dampened. Customers were encouraged to look elsewhere with conditions created so hostile that a few of the large borrowers were left in severe distress. The constraints around net counterparty exposure (10 or less units or net lending exposure of £20m) meant that landlords in £10m – £25m borrowing range were frozen out from seeking alternative options. Some of the 2nd tier lenders do market their cap at £20m but in reality this is not the case.
3. The stress test is completely turned on its head. Previously when the base rate was 0.50%, typically stress was applied at 5.5% with Debt Service Cover Ratio (DSCR) of 1.3x. I had always suggested that this was an inherently flawed risk management matrix since any fixed product ought not to be stress tested at 5.5%. The base rate at 5%+ meant lenders are likely to lend at 300bp+ margin (8% and over) hence this concept was fully exposed. A sensible approach would be to retain a sensible LTV (capped at 60% gearing), DSCR at 1.30x as rental receipts are often linked to RPI and any increase in rate could be offset by passing through onto the tenants.
4. We need an innovative approach in this segment. Capital should not be beholden to arbitrary rules or outdated regs so as to starve this sector of capital. Sponsors should not be penalised for their success in scaling their business. Whilst there is ample choice for sub £5m or £30m+ lending, the space is almost virgin territory. The likes of Investec, YBS commercial, Nuveen ought to pay more attention to this sector since their cost of capital is far more competitive than say Shawbrook, Interbay, Metro, Oaknorth, etc.
We need a disruption in this market and anyone brave enough to raise funds (ideally via market arbitrage from say Japanese institutions where cost of funds is far cheaper) will reap handsome rewards. The market for £5m – £25m is for the taking. I have studied this market for the last decade and so far am appalled at the way portfolio landlords are left at the mercy of their lenders. The ad-hoc loan covenants are so restricted that it is constraining the portfolio landlords to graduate their portfolios into the next league.