Intermediaries seeking a growth area should seriously consider commercial mortgages. A lot has been written about commercial mortgages over the last six months, with many trade publications predicting that commercial mortgages will be the next big thing in the UK mortgage market.
So, is it all hype? Well, over the last year the UK has witnessed unprecedented levels of interest from new commercial lender entrants. This interest has been both from foreign newcomers as well as existing UK lenders looking to expand their product offering and add a commercial proposition to their range. So why the sudden interest in the commercial mortgage market?
As a company, we are always seeking untapped markets in which to expand our commercial mortgage business. At the end of 2005 InterBay’s senior management team investigated the opportunities available in the UK. They discovered a strong demand for smaller sized (£50,000 to £600,000) self-cert commercial mortgages plus a strong broker community to service this consumer demand. InterBay identified a gap in the market for a broker facing lender who supplies small-scale self-cert commercial mortgages. The last 6 months has proven the perceived opportunity to be correct, with demand for the product doubling month on month.
Commercial options
It’s been reported that the percentage of commercial mortgages being placed via a mortgage intermediary is increasing – but what is causing this shift? It’s necessary to look at the borrowing options open to a small business owner or investor.
For a large proportion of these borrowers their first mortgage enquiry will be to their bank. Getting a mortgage from their bank is fine but only if they are deemed to be ‘mainstream’ applicants – that is to say that they have no need to self-certify their income and have no adverse credit history. Banks typically require their commercial mortgage borrowers to provide accounts, detailed business plans, forecasts and references. They are also required to meet the stringent rental cover requirements that the banks enforce.
Intermediary support needed
If a borrower falls outside this ‘mainstream’ category, then they may find it difficult to obtain a mortgage from a high street bank and require an alternative solution. This is when a broker can add value to the borrower – when they are underserved by the traditional lenders and in need of expert guidance.
Like the US and Canada, the UK has a vast group of business people who do not qualify for a mainstream mortgage. So where do they turn? Some never purchase their own property, finding it easier to lease instead. Some are forced to seek short-term finance from ‘hard money’ lenders who can impose extremely high rates and take the borrower’s residential property as security. This solution, which can be manageable in the short term, must have a solid exit strategy or it can leave the borrower in dire straights.
Thankfully, there are a number of specialist lenders who offer an alternative. Some specialise in mortgages for self-cert commercial borrowers who have relatively good credit histories. Others cater for borrowers who have experienced credit issues in the past.
Currently there is a real opportunity for brokers. For those already working within commercial mortgages, they have an increased choice of products and lenders to work with. For those new to commercial mortgages, they have access to support when entering this lucrative business for the first time.
Packagers and brokers
Typically, lenders who offer self-cert commercial mortgages do so via packagers and brokers. For a lender, opening a consumer channel comes at a massive cost. Even without the infrastructure of a high-street branch network, to build a respected brand name and communicate the product lenders would need to embark on national advertising and marketing campaigns. Add to large call centres to this and the cost can outweigh the rewards.
Mass marketing of this nature can be compared to looking for a needle in a haystack. Even with clever consumer segmenting and targeting, the chance of finding the right borrower, at the right time, with the right need is slim. Far better to work with brokers and packagers who already have borrower relationships, and can assess the needs of borrowers and place cases with the best provider.
Like the residential self-cert market, the commercial self-cert market will be dominated by the broker. Indeed, brokers and packagers will constitute their distribution channel.
Obviously, there is a significant opportunity for packagers and brokers to expand their businesses by including self-cert small commercial mortgage loans into their selling efforts or panels. This should be viewed as an opportunity comparable to the early days of self-cert or buy-to-let.
Many brokers have little or no experience in commercial mortgages and quite often have preconceived notions about how difficult it is to place and complete a commercial mortgage application. Common misunderstandings are that cases will take a long time to process and only have a small chance of completing. These notions are usually born out of processes and procedures of large commercial cases undertaken by the high street banks. In some instances, brokers wait ages for the ‘long maybe’ only to be told ‘no’ later down the line – damaging their reputation with their client and putting them off working with commercial mortgages in the future.
It needn’t be like that. For smaller self-cert mortgages, lenders have designed application processes and criteria around self-cert residential mortgages – keeping it simple and making the application process quick and straightforward.
It’s not surprising that brokers are migrating to commercial mortgages. With standard residential mortgages earning a 0.35 per cent proc fee and commercial paying a proc fee in the region of 2 per cent, it’s a lucrative income stream that is welcomed in a time when many are feeling the squeeze.
It’s not hard to move into commercial mortgages. Many lenders offer seminars to cover the basics. A broker who has dealt with residential mortgages will find the transition to commercial an easy one to make.
DSCR
What needs to be made aware to the residential only brokers is that the credit underwriting of the borrower is the same for a self-cert commercial loan as it is for a self-cert residential loan. The added commercial component is the adequacy of the rental cover. This is often referred to as Debt Service Coverage Ratio (DSCR), which commercial lenders will quote as a percentage. It’s derived from dividing the annual rental payments by the annual capital and interest payments to create the ratio. DSCR is the amount of cash flow above the required cash to service the mortgage.
The ideal DSCR, or rental cover ratio, is 120 per cent or above, as this is believed by most commercial lenders to provide a sufficient margin for unforeseen financial demands that either increase the borrower’s outgoings or reduce the rental income from the property.
The self-cert commercial lenders use the annual rental income from the valuation report to derive the DSCR or rental cover ratio. It is neither complex nor difficult for most borrowers and intermediaries to estimate DSCR or rental cover ratio to determine if it meets the lender’s criteria.
Additionally, where the high street banks have no exception to their rental cover ratio of 120 per cent, some self-cert commercial lenders utilise flexible underwriting. In some instances, self-cert lenders will go below 100 per cent, which means the lender is willing to lend on a property where the annual rent is less than the annual capital and interest payments. In fairness, lenders who go below 100 per cent rental cover ratio do so for owner occupied or owner operated properties, but not investment properties.
Status versus self-cert
If a borrower can provide all the necessary paperwork to satisfy the high street bank’s needs and they are happy with the bank’s charges and conditions, they are well advised to obtain a mortgage from that source as it will invariably be at a lower rate than a self-cert deal. However, borrowers who cannot provide the required documents, because they are a new company or they do not have standardised accounting procedures, require a self-cert mortgage.
As well as fulfilling the demand for self-cert, these mortgages offer other advantages to the borrower and broker. Self-cert lenders do not need to see business accounts, P60s or other forms of income verification, making the underwriting process much simpler.
Self-cert commercial lenders price their products for risk but are not in the business of lending to borrowers who cannot repay the loan. This is in no ones’ interest and the lenders undertake careful checks to ensure the applicant has the ability to service the loan. To do this, lenders review the applicant’s credit history and may adjust the loan-to-value and the rate charge to reflect the risk. The applicant’s commercial and residential mortgage repayment history also plays an important part of the credit underwriting decision.
While an applicant might be asked by a self-cert commercial lender to explain past credit difficulties, this does not mean the loan request will be rejected. It is usually a case where the lender wants to confirm that the difficulty was a legitimate occurrence.
Self-cert commercial lenders vary as to the level of adverse credit they will consider, from light adverse to heavy adverse. Adverse commercial borrowers are not a significant proportion of the self-cert commercial market. Most self-employed individuals and owners of small businesses maintain reasonable credit histories in order to operate their business.
Commercial valuations
Although it doesn’t affect the borrower or the intermediary in a significant way, one of the major differences between a residential mortgage and a commercial mortgage is the valuation report. A commercial valuation report is more comprehensive than a residential report. Lenders need to understand the nature of the building and how it is / will be utilised. They also need to understand the commercial real estate market in terms of the trading environment and the general demand for rental properties in the area. The commercial valuation reports focus attention on specifics of tenancy quality and stability of rental income.
Commercial valuation reports are usually provided within 10 working days from instruction, which is considerably longer than a residential valuation report. The additional time is needed to allow the surveyor to locate appropriate comparable sales and rental properties. Unlike houses which vary only slightly in size and amenities and are readily comparable one to another, commercial properties have far less commonality.
Another distinct feature of a commercial mortgage is the need for an environmental screening to ensure that there are no known environmental issues with the property that would impact on the value or saleability.
Riding the commercial wave
If recent interest shown by brokers is anything to go by, the commercial market is about to see an influx of activity. This can only be positive as it increases choice for borrowers.
So long as the intermediary understands the simple DSCR ratio and is aware of which lenders to contact, they are able to assist a client with a small commercial mortgage on a self-cert basis. There are no accounts to be analysed, no business plans to be prepared or profit projections to be developed. The cases are very similar to self-cert residential and with the support of a good lender, the mortgage intermediary can soon be expanding their business potential and earning 2 per cent per completion.
