Please Note: This Article is 7 years old. This increases the likelihood that some or all of it's content is now outdated.

It wouldn’t surprise me to learn there are investors whose borrowing is so close to the edge that a nominal increase in Base Rate (and LIBOR) would tip them over the cliff,  but I should like to think that by now, after one of the longest bullish market runs, most landlords are sufficiently canny to have protected the bottom-line.

Fuelled by record low interest rates, an exuberant investment market for several years can lull buyers into a false sense of security. Not if but when Base Rate increases, it is not that the cost of borrowing would go up, that’s obvious, but the impact of higher interest rates on investor sentiment. Currently, commercial property investment prices are overinflated, because the market is in a bubble. When a means of support is mostly hot air, to fill gaps in the level of understanding, it only needs a cooling mechanism for the bubble to deflate, or an unexpected event to cause the bubble to pop. Whatever the future holds for the market, one thing I suggest is certain: a demand for more liquidity.

When banks relax lending criteria, the supply of credit is not necessarily underpinned by liquidity. Credit is a gamble on the money being repaid before the lender has to repay the depositor.  Depositors are in search of yield and even at the best of times cash is rarely regarded as a positive investment. The emphasis is on accumulating assets and spreading the risk.

Borrowers are in two separate camps. One is lent money on a debenture. the other borrows on each individual investment.  A debenture is best because the loan is a general credit, rather than on specific assets, which means the borrower has flexibility, but debentures are usually the product of an established track-record with the lender. More commonly, the investor will borrow on specific assets, which is less flexible.

A loan on a specific asset is normally a percentage of the value of the property.  The lender’s valuers provide the lender with at least two valuations: the market price of the proposition and a forced sale valuation. As to which value is adopted by the lender depends upon the particular lending criteria. In my opinion, and I have mentioned this elsewhere, surveyors should not value the investment, but simply value the property. The value of the investment aspect should be assessed separately, by the lender.

The difference between the value of the property and the value of the property investment is between the value with vacant possession and the value with the benefit of the lease that is in force.  That the difference could be substantial doesn’t matter because the lender would at least be forewarned. However, what normally happens, is that the valuer muddles the issues by assessing the market value of the investment, and a forced sale value of the investment. The lender is none the wiser because either way the value depends upon the investment, regardless of the fundamental value of the property.

Generally, the lender will advance a percentage of the investment value and the borrower will make up the difference between the amount of loan and purchase price with equity. for example, 40% equity, 60% loan.  Where the rent exceeds the cost of borrowing, the rental income, net of non-recoverable management costs, services the loan and depending upon the loan arrangement and the management expenses there may be some rent left over for the investor.  How much is left over goes toward the return on equity, or capital employed.

Clearly, an increase in interest rates which results in higher repayments of the loan is going to reduce the amount remaining for the landlord.  It is, however, not as straightforward as that. Periodically, lenders check whether the loan-to-value covenant (LTV)  is being maintained. LTV is the ratio of loan percentage to the investment property value so, depending upon how much of the loan has been repaid, any reduction in the market value of the investment is likely to reduce the equity. In order to maintain the LTV, the lender will require either that the investment be sold (the asset liquidated) or for the landlord to repay part of the loan, in practice to inject more equity.

Whether a loan can be rescheduled depends upon the banking relationship between lender and borrower. With loans on specific assets, there may be less flexibility, because each property would be assessed on its merits. The price paid for the investment will depend whereabouts in the bubble the property was bought. In extreme, there may not be anything much left after the market has returned to its senses. The investor is faced with cutting his losses, or negative equity.

All other factors remaining constant, the only ways an investment can grow in value is if the purchase price were too low to begin with or the market has moved higher. But the factor that does not remain constant, and over which the investor little or no control, is whether there is any likelihood of rental growth. An increase in rent and/or a restructuring of the lease could offset a reduction in capital value. Which brings us to the 64 million dollars question: why should the tenant want to pay a higher rent?

The pragmatic answer is that the tenant wouldn’t. The legal answer is that because of how rent reviews to market rent are done the tenant might not have any choice. But not having a choice doesn’t mean the tenant would concede without a fight. The absence of a standard form of business lease means that fights cost money, often non-recoverable expense. Non-receoverable expense reduces the return on equity. Fights also involve delay: investment market buoyancy may not last, investor sentiment could be on the wane.

Base Rate up one or two percent is nothing to worry about: of greater concern is whether the investor has enough liquidity to withstand the impact on LTV.












Please Note: This Article is 7 years old. This increases the likelihood that some or all of it's content is now outdated.


Please enter your comment!
Please enter your name here