INTM579030 - Thin capitalisation: lending against asset values: Lending against tangible assets - buildings and land

The following guidance covers situations where the property against which the loan is secured is an asset in an investment business. It does not for example cover loans made on owner-occupied property where one would expect the property to be part of a trading enterprise. Different considerations have to be taken into account in looking at loans in these circumstances because of the risks inherent in the trading aspect of the business. Neither does it normally cover residential property, certainly not of the type which has shown large fluctuations in the last few years: the buy-to let market.

In recent years there has been a move towards an op co (operating company)/ prop co (property-owning company) business model as trading companies have sought to release the value of their property assets to reinvest in their businesses. This has led to a proliferation of sale and lease back schemes involving many of the UK’s largest trading companies.

Until the credit crunch of 2008, the years since the millennium saw a rapid increase in property prices in the UK both for commercial and residential property. The UK in particular was seen as a good place to invest which resulted in an equally rapid increase in the amounts of money lent to investors both by UK and foreign banks. The UK commercial property market stood at around £762bn in 2007 of which approximately £200bn was owned offshore. (See the Investment Property Forum’s 2007 edition of Understanding Commercial Property Investment - A Guide For Financial Advisers, available on the Real Estate Investment Trust Association website http://www.reita.org/live/Knowledge_centre/library.html)

Much of the money used to invest in UK commercial property came in the form of loans from financial institutions. In 1997 the Department of Land Management at De Montfort University first published a report entitled ‘The UK Commercial Property Lending Market’. It covered the lending practises of financiers to that market. Since then the report has expanded considerably and it is now published annually with a half yearly update. It covers all the major lenders both from within the UK and outside and the vast majority of the smaller lenders. This should be the starting point in any consideration of what third parties might lend on the security of a UK commercial property.

Copies are held by the LBS property sector in Leeds, and by CAR Residency who deal with offshore companies with UK property holdings.

The De Montfort Report

The report is a useful indicator of what a third party would have lent on the security of a property. However it has to be used with care as it cannot give the answer in any particular case. Each case must be considered on its own merits, according to the facts and circumstances, and the De Montfort Report cannot provide a “safe harbour”. What it does is give a range of figures at which loans have been made. It is then a matter of considering where on the range the transaction in question would fall. This will depend on a number of factors.

The loan position consists of a “basket” of characteristics and the whole basket is considered when looking at whether the financing is arm’s length. Characteristics typically within the basket are: loan to value ratio, interest rate, security, covenants, payer’s cashflow projections, repayment terms, etc

The De Montfort Report shows the sort of factors which a lender would take into account. These would include, but not exclusively:

• Who the borrower was
• Who the tenant was
• The terms of the lease
• The property
• The business plan

The report looks at 3 types of commercial property:

• Retail
• Office
• Industrial

And splits each into two categories:

• Prime
• Secondary

These are defined as:

Prime: A rack-rented institutionally recognised lease on a new high specification property in a prime location let to an AAA covenanted tenant* for a minimum of 10 years certain

Secondary: A rack-rented institutionally recognised lease on a 20 year old property in a secondary location let to a BBB covenanted tenant* for a minimum of 10 years certain

(*a covenanted tenant is one where the risk of default on lease payments has been passed on to a third party, normally an insurance company. The credit rating refers to the tenant)

The report also gives figures about loans for property development. Specific reference should be made in each case.

For each of the 6 sectors (3 x 2 above) De Montfort gives the following information:

• Loan to value
• Margin
• Interest rate cover
• Lenders initial charges

The margin is expressed in basis points (100 basis points = 1%) over, say, 3 month LIBOR which is the usual method used in loan agreements. 3 month LIBOR tends to be used because interest is paid 3 monthly.

The information is given in the format of:

• Lowest
• Highest
• Average

There are different figures for each type of lender as well as an average of all of them:

• UK Banks
• UK Building Societies
• German Lenders
• American Lenders
• Other International Lenders

The Report contains a range of statistics, charts, and analyses covering comparisons of loan terms, interest rates, types and locations of lenders, etc. De Montfort’s Business & Law Faculty website gives a substantial extract of a previous report (http://www.dmu.ac.uk/Images/cplr_sample_report_tcm6-7435.doc).