1.  Commercial Mortgages

A commercial mortgage is a loan obtained to purchase, develop, or refinance land or property for business purposes, secured by a legal charge on that non-residential property. Unlike residential mortgages, commercial mortgages are backed by real estate multi-family apartments, offices, shops, warehouses, retail and industrial properties, rather than owner-occupied residential properties. The core differences are its high deposit requirements, usually larger loan amounts, and less rigid, less regulated terms from lenders.

1.1  Covenants

As a rule, the covenants in a commercial mortgage are more elaborate than those in a corresponding residential loan agreement. Covenants are promises made by the borrower to the lender and oblige the borrower to maintain the property and sustain the fulfil specified financial conditions. Failure to fulfil the covenants can result in default and render the full loan amount due forth with.

1.2  Recourse

Recourse entails how the loan is secured, such as the potential capability of the lender to take possession of the property in the event of a default and the potential ability of the lender to pursue recovery from the borrower’s other assets. Lenders may insist on minimum deposit or balance to be kept in an account with them.

1.3  Cross-Collateral Provision

A cross-collateral provision, or cross-collateralization is a clause that provides for an asset pledged as collateral for one loan is used as security for a second loan from the same lender. This raises a lender’s security, as defaulting on any of the restricted loans permits them to take possession of the pledged asset to cover the outstanding debt. Such provisions are widely known in different financing types, namely credit-card mortgages, structured deals- potentially offering borrowers benefits (e.g., lower interest rates), while increasing the risk of losing assets in the event of default.

1.4  Loan-to-Value (LTV) Ratio

 This ratio compares the mortgage amount to the appraised value of the property.

Key financial ratios for evaluating commercial mortgage default risk comprise of Loan-to-value (LTV) ratio, which estimates loan amount against property value. As with residential loans, the LTV ratio, both the origination of the loan and an ongoing basis, is a core measure used by lenders. The LTV is the ratio of the amount of the loan to the value (either market or appraised) of the property.

The LTV at which a lender will issue a loan varies depending on the lender, the property sector, and the geographic market in which the property is located, as well as the stage of the of the stage of the real estate cycle and other circumstances, such as the borrower’s creditworthiness.

This ratio compares the mortgage amount to the appraised value of the property

• LTV formula: Loan Balance / ( Deposit – property Value) = LTV Ratio

• High LTVs (above 80%) may be deemed high risk and could result in higher borrowing costs or a denial of the loan, as well as less equity in the property, which raises risk for the lender if property values fall.

• Impact on default risk: high LTV means less lender protection if property value falls.
• Debt Service Coverage Ratio (DSCR)

The DSCR is a financial metric that estimates a company’s or property’s ability to cover its total debt obligations, as well as principal and interest payments, using its net operating income (NOI). A DSCR higher than 1.0 suggests adequate cash flow to meet these obligations, with higher ratios signaling lower risk to lenders and investors.

• Formula for DSCR: Net Operating Income / Total Debt Service = DSCR

• What the DSCR Disclose

• Solvency: It indicates if a borrower can consistently pay its debts from its earnings or the income generated by an asset.
• Risk Assessment: Lenders and investors use DCSR to measure the risk linked with lending money or investing in a project, as lower DSCR can indicate potential cash flow difficulty.

• Example: A property with an NOI of £550,000 and annual debt service of £350,000 has a DSCR of 1.83 (£550,000 / £300,000 = 1.83). This means that property generates £1.83 for every £1.00 of debt service.

• Ratio Interpretation:

• DSCR > 1.0: The company generates adequate income to cover its debt.

• DSCR < 1.0: The company does not generate adequate income to cover its debt obligations.

• Higher DSCR: suggests stronger financial health and lower risk for lenders.

• Low DSCR: Indicates the property is not generating adequate cash flow to service the debt, increasing the probability of default. 

• Why These Ratios Are Important

• For Lenders: These ratios are fundamental tools for evaluating and managing the risk of commercial mortgage defaults, affecting loan approval decisions and allocation of capital. 

• For Borrowers: Comprehending these ratios helps borrowers to understand their own financial position and be eligible for more favorable loan terms. 

1.5  Interest Coverage Ratio (ICR)

 In real estate, the interest coverage ratio (ICR) estimates a property’s or investor’s capability to cover its mortgage interest payments using its rental income, usually calculated as a percentage of ‘passing rental’ versus ‘finance costs’. Lenders use the ICR to evaluate risk and affordability for buy-to-let (BTL) mortgages, making sure that rental income can sustain the loan. For example, a common requirement is minimum ICR of 125%, signifying that the rental income must exceed the interest payment by 25%.

• Formula for Calculating Interest Coverage Ratio (ICR): (Annual Gross Rental Income / Annual Finance Costs) x 100 = ICR

OR

• Monthly Gross Rental Income / Monthly Finance Costs) x 100 = ICR

Why the ICR is Significant

• For Lenders: It is a vital risk management tool to make sure that borrower can meet debt obligations and that the property can guarantee the mortgage payments, even if interest rates increase.

• For Investors: It shows that the property’s financial robustness and ability to cushion (sustain) future expenses, such as property maintenance, taxes, and unexpected costs.

Characteristic ICR Requirements

• Lenders usually set a minimum ICR, such as 12%. This defines the gross rental income must be 25% higher than the mortgage interest payment.

• A higher ICR suggests a healthier financial position and lower risk for the lender.

1.6  Mortgage Stress Rate (MSR)

A mortgage stress rate is a hypothetical interest rate, higher the actual rate that lenders use to test if a borrowers can afford their repayments should interest rates increase. The MSR is used for Buy-to-Let (BTL) mortgages, to ensure that a borrower’s financial stability and decrease the lender’s risk.

How the Mortgage Stress Rate works:

• For Residential Mortgages

Lenders use a stress rate as part of an affordability test/check for borrowers taking out a mortgage with an initial rate fixed for less than five years. If rates increase unexpectedly, the lender realizes that the borrower can still comfortably meet their repayments. However, since 2022, it is no longer a compulsory requirement for UK residential mortgages, but many lenders still apply some form of stress testing.

• For Buy-to-Let (BTL) Mortgages

This measure is till critical and compulsory part of the affordability evaluation. The lender uses the stress rate to ascertain if the rental income from the property is adequate to cover the mortgage payments, encompassing a safety buffer, in case of future interest rate rises.

There is no specific “mortgage stress rate” formula, as the test is used in different ways, but a common method for buy-to-let mortgage is the “Stress Interest Coverage Ratio (SICR), computed as:

• SICR = (Rental Income /2) / (Loan Amount x Stress Rate / 2)

• Note: A specific percentage above the calculated interest, the Rental Cover ratio (between 125% and 145%), is required, which means the rental income must exceed the interest payment to pass the stress test.