Commercial mortgages, and what happens when the target owns its premises

What a commercial mortgage is

A commercial mortgage is long-term lending secured by a legal charge over a commercial building. It is the longest and usually the cheapest money in business finance, for a straightforward reason: the security is a real asset that exists whether or not the business trading from it does.

There are two versions and they are assessed on completely different grounds.

Owner-occupied lending funds premises the business itself will trade from. The repayment source is the trading profit of that business, so the lender is underwriting the trade as much as the bricks. It is closer to a business loan that happens to have a building behind it.

Commercial investment lending funds a property that is let to a tenant. Here the repayment source is the rent, so the assessment turns on the lease and the tenant rather than on the borrower's own trading. The borrower's job is to be a competent landlord and to have somewhere to go when the lease ends.

Where it shows up in an acquisition

Most buyers meet a commercial mortgage without going looking for one, because the business they are buying owns its premises. That turns one purchase into two, and the decision about how to handle it has consequences well beyond the funding.

Three routes are common. The building can be bought alongside the trade, usually by a separate property company with the trading company as tenant. The seller can keep the building and grant a lease, which lowers the price and raises the trading business's fixed costs for years. Or the property can be bought later, once the trade has settled, with the seller granting a lease and an option.

Each of those changes what the trading business earns, and therefore what senior term debt can be serviced from. A rent that did not exist before is a permanent cost that comes straight out of the profit the acquisition loan is repaid from, and a lender will model it whether or not the buyer has. Whether the deal is structured as shares or assets also decides who owns what afterwards, which is set out in share purchase versus asset purchase.

How the loan is sized, and what the valuer is really deciding

The loan is a proportion of value, and value is set by the lender's own valuer rather than by the price agreed. Where a valuation comes in below the price, the lender lends against the lower figure and the difference lands on the buyer, in cash, late in the process.

On specialised buildings the valuer usually reports two figures: what the property is worth in its current use, and what it would fetch with vacant possession to a general buyer. Lenders size against the second one on anything purpose-built, because that is the number that matters if they ever have to sell it. A unit with one plausible occupier in the county is worth less to a lender than the owner believes, however good the business inside it is.

Around the valuation the lender is checking a list that is nearly always the same: tenure and any unexpired lease term, planning use, condition and repairing obligations, the energy performance rating and whether it meets the minimum standard for letting, environmental history on anything industrial, access and rights of way, and whether the property can be sold separately from the business.

How it is priced and repaid

• An arrangement fee is charged on the facility, normally on drawdown.
• Interest is a margin over a reference rate, with fixed periods available on many facilities. A fixed rate usually carries an early repayment charge, which matters if the plan is to sell or refinance before the fix ends.
• Terms are long compared with business lending, and repayment is normally capital and interest. Interest-only is sometimes available on investment lending where there is a defined exit.
• The valuation fee is paid up front and is not refundable if the answer is unwelcome, which is why the property questions are worth asking before it is instructed.
• Legal costs on both sides fall on the borrower, along with search fees and the cost of registering the charge.
• A personal guarantee is common on smaller facilities and on anything owner-occupied, and how one behaves in practice is set out in personal guarantees explained.

The lender will quote terms once the valuation is back and the legal title has been reviewed. Until then, any figure is a guess, and the parts of the offer most likely to move are the term and the repayment profile rather than the margin.

Who it suits, and who it does not

It suits a business that intends to be in the building for a long time and can evidence that the trade supports the payments. It suits a buyer who wants the property outside the trading company, so that a future sale of the trade does not force a sale of the premises. And it suits an investment purchase where the lease has real term left on it and the tenant is one a lender recognises.

It is the wrong product where the hold is short. A building being bought to be improved and sold, or a purchase that has to complete before a sale elsewhere does, is a job for bridging, with the commercial mortgage as the exit rather than the entry. It is also a poor fit where the property is unusual enough that the vacant possession value is a fraction of the price, because the shortfall becomes the buyer's cash problem.

What goes wrong

The valuation lands under the price. The most common single failure, and the one with the least warning. It is worth forming a view on the vacant possession value early, especially on anything purpose-built.

The VAT was not funded. Where the seller has opted to tax, VAT is payable on the price at completion and reclaimed afterwards. The mortgage does not cover it. That gap has to be funded, and finding out late turns it into an emergency.

The tax and the fees were not funded either. Stamp duty land tax, legal costs, the valuation and the arrangement fee all fall due around completion, and none of them is in the loan.

The energy rating blocks the plan. A building that cannot lawfully be let in its current condition is a different asset from one that can, and the works to fix it are the buyer's cost. On an investment purchase this is a valuation question, not a detail.

The intra-group lease was an afterthought. Where a property company holds the building and the trading company occupies it, the lease between them is real. Its term, its rent and whether it is on full repairing terms all affect what the property is worth and what the trading business can service.

The leasehold turned out to be short. A lease with a modest unexpired term, or one with restrictive alienation provisions, limits both the loan and the future sale. This is a legal question that should be asked before the offer, not during due diligence.

What a lender will want to see

• The title, the tenure, and the lease or tenancy schedule where the property is let.
• The energy performance certificate and any works needed to meet the minimum letting standard.
• Planning use, and any conditions attached to it.
• Three years of accounts and current management figures for the occupying business, on owner-occupied lending.
• Tenant covenant information and payment history, on investment lending.
• The purchase contract, the VAT position, and the structure of the borrowing entity.
• An environmental report on industrial or former industrial sites.

The general order a lender asks for paperwork is in the document checklist, and the terms that appear on a mortgage offer and nowhere else are in the glossary. Where an existing mortgage is already on the building, the question is usually whether it can be carried over or has to be replaced, which is covered in refinance.

Getting the property question answered before it costs money

Property lending has a specific failure mode: money is spent on valuations, searches and legal work before anybody knows whether the deal is fundable. On an unusual building, or on a deal where the trade and the premises are being separated for the first time, that is an expensive way to find out.

We know this market and we know specific people who fund premises in the trades and professional sectors we cover, so you can find out what the property question is worth before the meter starts running. Tell us what the building is and how it sits in the deal, and we come back to you with who can fund it and what they will want the valuer to confirm.