INTM579050 - Thin capitalisation: lending against asset values: UK third-party practices - interest rate margins in property lending

An interest rate margin is most commonly expressed as a number of percentage points, or a number of basis points (1% = 100 basis points) above a reference rate. A reference rate is the underlying rate on which a floating rate is based. The rate used in the UK is most commonly one of the LIBOR rates (a benchmark rate). Thus, a rate may be expressed as LIBOR + 1.5% or LIBOR plus 150 basis points.

LIBOR (see INTM578030) and other inter bank rates are available for a variety of currencies and for different periods (one day, one month, three months, etc), LIBOR itself being available in the currencies quoted in London. There is no necessary geographic link between a banking centre and currency (i.e. LIBOR does not automatically mean pounds sterling). Variable rates for Euro borrowing are generally set by reference to EURIBOR (as with LIBOR but set by a European panel of banks).

Some general principles on lending against property are given below:

• it is probably true to say that lenders may be prepared to lend at lower margins when there is property as security than when it is not, assuming that the borrower’s ability to service the debt does not produce additional risk to the lender.
• loans made on investment property generally carry a lower margin than pre-let developments, with speculative development carrying the highest margin.
• minimum interest rates are incorporated in loan offers to ensure that in times when Base Rate is dropping the bank’s rate of return is protected. This is irrespective of the size of the loan.
• in considering the appropriateness of a margin it is useful to take a line from external sources, which is why De Montfort (see INTM579030) is useful - if a margin is high it may be an indication of a thinly capitalised company because margins where the lending is adequately secured against assets are typically tight.

Similarly, a useful third-party comparator may be any loan taken out by the parent company for onward lending to the subsidiary purchasing the property. However, it will be necessary to look at the group structure and security aspects of the onward loan to check that any appropriate adjustments may be made.

There may be several “tiers” of loan finance, for example senior debt (usually the first and biggest tranche), mezzanine debt and junior debt. Senior debt is usually more secure and the junior debts more risky, so loan amounts, repayment terms and margins are likely to differ between the tranches. Generally, the margin will increase as the lender’s risk increases.

Margins may be affected by the presence of additional loans, dependant on the terms of the additional loans, their relationship to the senior debt and the effect on the cash flow of the borrower.

There may be some value in looking at the terms of loans taken out by the parent and on-lent to the property-owning company, though it can be difficult to establish that terms are not distorted by the size, reputation, etc, of the original borrower.