APC Series: Property debt financing 101

Jen Lemen outlines what APC students should know about debt, mortgages, interest rates and more. Property finance and funding is one of the RICS APC technical competencies. It is a requirement to Level 3 for candidates pursuing the property finance and investment pathway, and can be selected as an optional technical competency on other pathways, such as commercial real estate and valuation.  Moreover, having an understanding of how property purchases can be funded is essential general knowledge. Many candidates will encounter buying their own property with a mortgage during their working lives, for example. With much furore in the press currently about residential mortgages, we will build on the understanding gained from our last article on economics. Why debt? Starting with the basics, property purchases are financed for a variety of reasons. These include not having sufficient capital to fund the whole purchase and wanting to be exposed to leverage (ie increasing returns by using borrowed capital).  In very basic terms, property finance comes in two main forms: equity and debt. We will be focusing on debt financing in this article, which is where the lender loans money to the borrower to purchase a property, usually for a specific period during which the lender receives interest payments. When considering the sources of finance that a company uses, it is helpful to understand the term “capital stack”. We will look at some of these terms in further detail below.  Debt can be secured or unsecured. Unsecured debt (also known as subordinated, or junior, debt) is where the lender holds no collateral in return for making the loan, such as a credit card. Secured debt (also known as senior debt), which we will be focusing on, is where the loan is backed by an asset as collateral, such as a mortgage lender having a charge over the property. If the loan is not paid back (ie the borrower defaults), then the lender will be able to repossess the property. If a borrower defaults, then senior debt is repaid first, followed by subordinated (or junior) debt. This represents the riskiness of the debt tranches and will be reflected in the interest rates and loan terms agreed. Mezzanine finance, which is paid out after both senior and junior debt, is a combined form of debt and equity finance. It can be used to provide additional capital after a secured loan has been taken out, as well as limiting a company’s exposure to equity investment. Mortgages We will now turn towards the most common form of secured debt finance – mortgages. Mortgages are used to purchase property, whereby the capital is borrowed over a fairly long period of 25-plus years. Most high street banks provide mortgage finance for residential owner-occupier purchases, although there are more specialist lenders for other asset types, such as houses in multiple occupation, buy-to-lets and commercial properties. Mortgages require a deposit to be put down by the borrower, which represents the loan-to-value ratio. These typically range from 60% to 95%.  By way of example, a property worth £200,000 and the borrower has a deposit of £20,000. Their loan-to-value ratio would be 90%. A lower loan-to-value ratio will typically attract a lower interest rate, as the risk for the lender is lower. House prices can rise and fall, so having a high loan-to-value ratio can be risky if house prices fall, as the loan can end up being greater than the value of the property. This is also known as negative equity. Mortgages can either be capital repayment or interest-only. With a capital repayment mortgage, each monthly payment includes both an element of capital and of interest. With an interest only mortgage, the monthly repayments cover the interest only, so the capital balance will remain the same at the end of the term. Typically, interest-only mortgages will have lower monthly repayments, reflecting the fact that the capital is not reducing over the term. Interest rates No doubt readers will be aware of the discussion in the press about current mortgage interest rates.  These rates have increased in the latter part of 2022, primarily due to the increase in the Bank of England base rate (to 3% in November 2022).  The interest rate agreed as part of the loan terms will influence the amount of the monthly repayments. Other fees will also be payable as part of the loan terms, usually including a product fee, application fee, valuation fee and transfer fee. Mortgages also often come with other fees attached, such as an early repayment charge and exit fees. On the point of interest rates, mortgages can be set on a variety of interest rate bases, including variable and fixed rates. Variable rates are not fixed and will vary according to the Bank of England base rate – this can lead to unpredictable and uncertain repayment costs over the mortgage term. Fixed-rate mortgages are usually fixed for a period of one to five years and provide certainty to the borrower of monthly repayments. Valuation With any form of debt financing, the borrower will assess the risk of providing the loan through due diligence and underwriting. This means that they can offer loan terms commensurate to the risk of providing the loan.  The lender will consider a variety of factors, including the credit rating of the borrower, property-specific risk, default risk and market yields for similar loans. The lender will also carry out due diligence into legal, financial and asset-specific issues, which will be informed by a secured lending valuation of the property. For surveyors providing secured lending valuations, their client will be the lender (not the borrower). However, the surveyor still owes a duty of care to owner-occupier borrowers following the combined cases of Smith v Eric S Bush (a firm); Harris and another v Wyre Forest District Council and another [1989] 1 EGLR 169.  However, this duty of care is not extended to more “educated” borrowers, such as buy-to-let or commercial investors, following Scullion v Bank of Scotland plc (t/a Colleys) [2011] EWCA Civ 693; [2011] 3 EGLR 69. The RICS provides extensive guidance on secured lending valuations, both in the Red Book Global, UK National Supplement and supplementary guidance notes.  In conclusion, there are a variety of forms of debt financing for property purchases. The most common is mortgage finance for residential properties. Surveyors are likely to encounter debt finance in their roles, whether through secured lending valuations, debt financing in a development appraisal or residual valuation or through their own home purchase.  Being aware of how debt finance works and how interest rates are affected by the market is essential general knowledge, and key in advising clients in a variety of instructions. Further reading and resources Red Book Global, RICS  RICS guidance note, Valuation of Buy to Let and HMO Properties (2nd edition) RICS guidance note, Risk, Liability and Insurance (1st edition) Jen Lemen BSc (Hons) FRICS is a co-founder and partner of Property Elite Photo by Jason Alden/Shutterstock (2443846d)