Most people agree that it’s rarely a good idea to take a one-size-fits-all approach, especially with property finance. It may be convenient and efficient but it rarely produces optimum results for clients.
Yet this is the approach many commercial mortgage lenders are adopting towards 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 don’t quite fall into the commercial bucket either. These are assets such as purpose-built student accommodation, short lets, serviced housing or other properties with an element of care but not full-blown care homes.
I feel this is an area that is ripe for innovation
Typically, these properties have a longer rental agreement in place than that of, 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 nine months a year, whereas an AST can last 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 these are classified as commercial premises. That means, when it comes to underwriting, they are 100% risk weighted. That risk weighting can add two percentage points or more to the loan rate.
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
The issue is that 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.
Planning
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 usage class.
Short-term lets tend to fall under the same category as hotels (C1), while sheltered housing and care homes typically fall under C2.
Is there a way for banks to offset this lower-margin lending with higher margins made elsewhere?
A lot of lenders have no appetite to lend on some of the property types 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 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 might have to take a margin hit, which they don’t like doing unless they have to. But I am confident that the volumes would more than compensate.
Regulation
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 in case the loan defaults. Commercial premises are considered riskier than residential, so banks must hold more capital aside for these types of mortgage.
Lenders might have to take a margin hit. But I am confident that the volumes would more than compensate
Those rules are set to become more onerous for commercial mortgage lenders with the introduction of the Basel 3.1 standards 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-margin lending with higher margins made elsewhere?
This practice is commonplace in other areas of retail banking.
Why do lenders take this approach? There are two major reasons, the first being the planning system
That’s a decision for 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 lender willing to take the time and effort to construct such a product, I’m sure the rewards would be worth it.
Lucy Waters is managing director of Aria Finance
This article featured in the July/August 2024 edition of Mortgage Strategy.
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