How do interest rates on commercial mortgages work?

For businesses seeking finance to purchase or refinance commercial property in the UK, understanding the mechanics of interest rates is paramount. Unlike residential mortgages, commercial lending operates under fewer regulations, allowing for greater negotiation but also introducing higher complexity and varied pricing models. The rate you are offered depends less on a standardised scale and more on a detailed assessment of your specific business risk and the characteristics of the property being mortgaged.

Understanding How Do Interest Rates on Commercial Mortgages Work in the UK?

Commercial mortgage interest rates are essentially the cost of borrowing capital, calculated as a percentage of the outstanding loan balance. This cost is determined by two primary components: the reference rate (which tracks market conditions) and the lender’s margin (which accounts for risk, operational costs, and profit).

Core Components of Commercial Mortgage Interest Rates

The structure of a commercial mortgage rate can often be simplified into a formula:

Interest Rate = Reference Rate + Lender’s Margin

Both components fluctuate based on macro-economic conditions and specific borrower factors, meaning no two loans, even for similar amounts, will necessarily have the same pricing.

The Reference Rate: Bank of England Base Rate and SONIA

The reference rate is the economic benchmark that dictates the fundamental cost of funds for the lender.

• Bank of England (BoE) Base Rate: This is the key monetary policy tool used by the UK central bank. Changes to the Base Rate directly influence how much commercial banks pay to borrow money. When the Base Rate rises, commercial lenders’ cost of funds increases, and they typically pass this increase onto borrowers through variable or tracker rate mortgages.
• SONIA (Sterling Overnight Index Average): Following the phasing out of the previous benchmark, LIBOR, SONIA is now the preferred near risk-free reference rate for most new UK commercial loans. SONIA is based on actual transactions in the overnight sterling deposit market. Many modern variable or floating rate commercial loans are priced based on SONIA, plus the agreed margin.

If your commercial mortgage is variable or tracked, movements in the Base Rate or SONIA will cause your repayments to change.

The Lender’s Margin (Risk and Profit)

The margin is the percentage added by the lender above the reference rate. This element is non-negotiable once the loan is established (for the duration of a fixed rate period, or as a set percentage for a variable loan), and it covers several critical factors:

• Risk Assessment: This is the largest factor. The lender assesses the probability of the borrower defaulting. A higher perceived risk warrants a higher margin.
• Operational Costs: Costs associated with managing the loan, including processing, administration, and regulatory compliance.
• Profit: The return the lender expects to make on the capital deployed.

The lender’s margin is highly specific to the borrower and the deal, which is why comprehensive due diligence is required during the application process.

Key Factors Influencing Your Commercial Mortgage Rate

Lenders meticulously evaluate several factors before setting the final margin. Understanding these factors can help businesses present a stronger application and potentially secure a lower rate.

Loan-to-Value (LTV) Ratio

The LTV ratio is perhaps the most significant determinant of risk in property finance. It expresses the loan amount as a percentage of the property’s valuation. For example, a £750,000 loan on a £1,000,000 property is 75% LTV.

• Lower LTV: Means the borrower has a larger equity stake in the property. This reduces the risk for the lender, as the lender has a greater protective buffer should property values fall. Loans with lower LTVs (e.g., 50% to 65%) typically attract significantly lower interest rates.
• Higher LTV: Increases the lender’s exposure. Commercial mortgages rarely exceed 75% LTV, and loans at the higher end of this scale will command a greater margin.

Borrower Risk Profile and Business Sector

Lenders need confidence that the business can generate sufficient, consistent cash flow to cover the mortgage repayments. They will scrutinise:

• Financial Health: Analysis of the business’s accounts, profit and loss statements, and cash flow projections, typically over the last three years.
• Sector Stability: Businesses operating in volatile or high-risk sectors (e.g., certain hospitality or highly niche manufacturing) may face higher rates than those in established, stable sectors (e.g., professional services or general office space rental).
• Management Experience: The lender will assess the track record and experience of the individuals running the business.
• Credit History: The credit history of the business and its directors is reviewed. Any defaults, County Court Judgments (CCJs), or history of poor financial management will increase the perceived risk and therefore the interest rate offered.

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Property Type and Usage

The ease with which the property could be sold if the borrower defaults (its liquidity) affects the rate. Standard commercial properties are generally easier to finance than specialised ones:

• Standard/Investment Properties: Office buildings, warehouses, or retail units that can be easily let or sold tend to attract lower rates.
• Specialised Properties: Hotels, nursing homes, petrol stations, or properties requiring bespoke fit-outs are considered higher risk because the pool of potential future buyers or tenants is smaller, making repossession and recovery harder. These property types typically incur a higher interest margin.

Loan Term and Size

Generally, shorter loan terms (e.g., 5 years) carry different risks than longer terms (e.g., 25 years). Lenders often prefer loans where the immediate future cash flow is predictable. Very large or very small loan sizes can also influence the pricing:

• Larger loans may sometimes attract a marginally keener rate due to better economies of scale for the lender, provided the borrower’s finances are exceptionally robust.

Fixed Rate vs. Variable Rate Commercial Mortgages

Borrowers must decide whether they prefer certainty in payments (fixed rate) or the potential for lower repayments if rates fall (variable rate).

Fixed Rate Mortgages

A fixed rate means the interest rate charged remains constant for a defined period (typically 2, 3, 5, or sometimes 10 years), regardless of movements in the Bank of England Base Rate or SONIA. At the end of the fixed period, the loan reverts to the lender’s standard variable rate (SVR) or a tracker rate.

• Benefit: Provides stability and makes budgeting easier, protecting the business against sudden interest rate spikes.
• Risk: If market rates fall significantly, you will be locked into a higher rate. Early repayment or refinancing during the fixed period usually incurs substantial Early Repayment Charges (ERCs).

Variable Rate Mortgages

Variable rate commercial mortgages, often tied directly to a reference rate like SONIA or the lender’s SVR, can fluctuate throughout the term of the loan.

• Benefit: Allows the business to benefit immediately if interest rates fall, potentially saving significant costs.
• Risk: Exposes the business to volatility. If interest rates rise, repayments could increase rapidly, potentially straining the business’s finances.

Tracker Mortgages

A specific type of variable mortgage, a tracker rate is explicitly linked to an external benchmark (most commonly the BoE Base Rate) plus a specific, fixed margin. For example, Base Rate + 3.0%. The margin remains constant, but the overall interest rate moves directly in line with changes in the benchmark.

Understanding Associated Costs and Fees

When calculating the true cost of borrowing, businesses must look beyond the quoted interest rate (the nominal rate) and calculate the Annual Percentage Rate of Charge (APRC), which incorporates all mandatory fees.

Typical associated costs can significantly inflate the total repayment burden:

• Arrangement/Facility Fee: Charged by the lender for setting up the loan. This is often between 1% and 3% of the total loan amount and is often deducted from the loan proceeds at completion.
• Valuation Fee: Paid by the borrower to cover the cost of the independent valuation required by the lender.
• Legal Fees: Borrowers are usually responsible for the lender’s legal costs as well as their own.
• Exit Fees: Some commercial mortgages, particularly those offered by non-bank lenders, may include a fee payable upon full repayment of the loan, regardless of when this occurs.

A seemingly low interest rate combined with high arrangement and exit fees could result in a higher overall cost of finance than a mortgage with a slightly higher nominal rate but lower fees.

Protecting Yourself Against Rate Changes

If a business chooses a variable rate, or if it has large loans that will revert to SVR, implementing strategies to manage interest rate risk is crucial.

Lenders may offer tools to mitigate risk, such as:

• Interest Rate Caps: A contractual agreement limiting how high the interest rate on the loan can rise over a defined period.
• Interest Rate Collars: A combination of a cap and a floor, ensuring the rate stays within a specified range.
• Fixed-Rate Conversions: An option to switch a variable rate loan to a fixed rate at specific points in time.

For large corporations or businesses highly sensitive to interest rate fluctuations, using financial derivatives like interest rate swaps may be considered, although this is complex and requires specialist advice.

Understanding the UK economic outlook is vital when making long-term borrowing decisions. The Bank of England provides regular updates on monetary policy and economic forecasts, which can help businesses anticipate potential changes to the Base Rate. For further information on financial stability and current lending conditions, consulting resources like the Bank of England’s Monetary Policy Committee reports is advisable. You can access official economic statements on the Bank of England website.

People also asked

Are commercial mortgage rates higher than residential rates?

Typically, yes. Commercial mortgage rates are generally higher because the loans are considered higher risk due to greater market volatility, fluctuating business income, and less regulatory protection compared to standard owner-occupied residential mortgages.

What is a covenant in a commercial mortgage agreement?

Covenants are conditions and promises made by the borrower within the loan agreement, often relating to maintaining specific financial ratios (like debt service cover ratio) or restricting major changes to the business without lender consent. Failure to meet these covenants, even if payments are current, may constitute a default.

How much deposit do I need for a commercial mortgage?

The minimum deposit usually required for a commercial mortgage in the UK is 25% of the property value, reflecting a maximum Loan-to-Value (LTV) of 75%. However, a larger deposit (e.g., 35% or 40%) will often lead to significantly more favourable interest rates.

Can I roll up interest payments on a commercial mortgage?

While interest roll-up is common in short-term bridging finance, commercial mortgages typically require interest payments (and often capital repayments) to be made monthly throughout the term. Roll-up arrangements are rare for long-term commercial loans.

Do lenders use the Bank of England Base Rate or SONIA for commercial mortgages?

Most new variable commercial mortgages use SONIA as the primary reference rate, as it is the standard replacement for LIBOR. However, some loans, especially tracker products, may still be explicitly linked to the Bank of England Base Rate plus an agreed margin.

Navigating commercial mortgage interest rates requires careful consideration of both the macro-economic environment (reference rates) and the specific financial health and risk profile of the borrowing entity (lender’s margin). By thoroughly preparing financial documentation, maximising the deposit contribution, and understanding the implications of fixed versus variable rates, businesses can significantly improve their chances of securing competitive commercial finance.

Remember that commercial finance is a negotiation, and seeking independent financial advice is crucial to compare offers and select the most appropriate structure for your business needs.