By Lucy Waters - Managing Director for Aria Finance
Mortgage Solutions - September 2024
Most people agree that it's rarely a good idea to take a one-size-fits-all approach, especially when it comes to property finance. While it may be convenient and efficient, it rarely produces optimum results for clients.
Yet this is the approach many commercial mortgage lenders are taking when it comes to underwriting certain types of asset.
The types of property I am talking about are those which, intuitively, don't quite fall into the residential bucket but also don't quite fall into the commercial bucket either.
These are assets such as a purpose-built student accommodation, short-lets, serviced housing or other properties where there is an element of care but are not full-blown care homes.
Typically, these properties have longer rental agreements in place than, say, an AirBnb, but shorter than a standard Assured Shorthold Tenancy (AST).
For example, a student would typically occupy a room in purpose-built student accommodation for around 9 months a year, whereas an AST can last anything from six to 12 months, or even longer.
A contractor, on the other hand, may rent a short-let property for a few months until the project they are working on is finished.
What I often find is that borrowers who invest in these types of asset often feel as though they are investing in a high-yield residential property. As a result, they want residential pricing.
However, to the lender, they are classified as commercial premises. That means, when it comes to underwriting, they are 100% risk weighted. That risk weighting can add 2 percentage points or more to the loan rate.
The issue is the higher rate can wipe out any additional yield investors can achieve by investing in these assets. It almost defeats the point of investing in them in the first place.
The big question is, why do lenders take this approach? There are two major reasons, the first being the planning system.
In this country, purpose-built student accommodation is designated "suis generis" for planning purposes, meaning it does not fall within a specific use class.
Short-term lets tend to fall under the same category as hotels (C1), while sheltered housing and care homes typically fall under C2.
A lot of lenders have no appetite to lend some of the property types that I have listed above. But for those that do, I feel this is an area that is ripe for innovation.
In an ideal world, many of these assets, particularly student lets, would be classed as residential premises and would be underwritten accordingly. However, I realise this is unrealistic.
Instead, perhaps there is scope for a hybrid product that sits between residential and commercial when it comes to criteria and pricing.
It would mean lenders may have to take a margin hit, which they don't like doing, unless they have to. But I am confident that the volumes would be there to more than compensate.
That brings us back to why this product doesn't exist in the first place. As I stated above, planning is a major issue, but regulation also provides hurdles.
When banks lend on a property, they have to hold a certain amount of capital aside just in case the loan defaults.
Commercial premises are considered riskier than residential, therefore banks must hold more capital aside for these types of mortgages.
Those rules are set to become more onerous for commercial mortgage lenders with the introduction of Basel 3.1 in January 2025, unless something changes.
But where there's a will, there's a way. There are some incredibly bright people working at banks, especially in the product design and treasury departments.
I don't claim to know the ins and outs of bank funding models, but is there a way for banks to offset this lower margins lending with higher margins made elsewhere? This practice is commonplace in other areas of retail banking.
That's a decision for the lenders, of course. And I'm sure it'll be a while before we see this type of product emerge - if it ever does - otherwise someone would have launched it to market already.
But the demand is there. Were it possible and were any lenders willing to take the time and effort to construct such a product, I'm sure the rewards would be worth it.
