Commercial Property Investment: Funding Your First Deal

Commercial property investment offers attractive returns, portfolio diversification, and potential for capital growth. However, securing finance for your first commercial property deal requires understanding a different set of lending criteria, metrics, and processes compared to residential mortgages.

What is Commercial Property?

Commercial property includes any property used for business purposes:

Property Types

Retail: Shops, shopping centers, retail warehouses Office: Office buildings, business centers, coworking spaces Industrial: Warehouses, factories, distribution centers Leisure: Restaurants, gyms, hotels, entertainment venues Mixed-use: Properties combining residential and commercial elements Healthcare: Medical centers, dental practices, care homes Student accommodation: Purpose-built student housing (PBSA)

Why Invest in Commercial Property?

Higher Yields

Commercial properties typically generate 6-10%+ gross yields compared to 4-6% for residential buy-to-let.

Longer Leases

Commercial leases often run for 5-25 years, providing stable, predictable income.

Tenant Responsibilities

Many commercial leases are "Full Repairing and Insuring" (FRI) - tenants cover maintenance, repairs, and insurance.

Professional Relationships

Commercial tenants are businesses, often resulting in more professional tenant relationships.

Upward-Only Rent Reviews

Many commercial leases include rent reviews (typically every 3-5 years) that can only increase, never decrease.

Commercial Mortgage Basics

Commercial mortgages differ significantly from residential lending:

Loan-to-Value (LTV)

Typically lower than residential:

• Owner-occupied: Up to 75% LTV
• Investment/buy-to-let commercial: 65-70% LTV
• Higher risk properties: 50-60% LTV

This means larger deposits are required - expect to invest 25-40% of the purchase price.

Interest Rates

Commercial rates are typically 1-2% higher than residential:

• Current range: 5-8% depending on property, borrower, and LTV
• Fixed rates: 3, 5, 7, 10 years common
• Variable rates: Available but less common

Terms

Commercial mortgages typically offer:

• Loan terms: 5-25 years (25 years less common)
• Interest-only options: Available, often preferred
• Repayment flexibility: More options than residential

Key Lending Metrics

Debt Service Coverage Ratio (DSCR)

The most critical commercial lending metric. DSCR measures whether rental income adequately covers mortgage payments.

Formula: Annual Rental Income / Annual Mortgage Cost

Lenders typically require:

• Minimum DSCR: 1.25-1.30 (125-130%)
• Stress tested: At higher interest rates (typically 1-2% above actual rate)

Example:

• Annual rent: £30,000
• Annual mortgage payment: £22,000
• DSCR: £30,000 / £22,000 = 1.36 (acceptable to most lenders)

Rental Coverage Calculation

Lenders stress test rental income at elevated interest rates:

Example:

• Property value: £400,000
• Loan required: £280,000 (70% LTV)
• Stress test rate: 6.5%
• Annual interest: £280,000 x 6.5% = £18,200
• Required rental income (at 130% DSCR): £18,200 x 1.30 = £23,660
• Monthly rental income needed: £23,660 / 12 = £1,972

If the property rents for £2,500/month, it comfortably passes rental coverage.

Eligibility Criteria

Personal Financial Position

Lenders assess:

• Credit history: Clean credit file essential
• Income: Proof of ability to support mortgage if rental income falls short
• Experience: Property investment or business experience valued
• Age: Some lenders have maximum age limits at loan end

Property Assessment

Lenders evaluate:

• Location: Prime locations preferred
• Condition: Property must be in good repair
• Tenure: Freehold or long leasehold (typically 70+ years)
• Tenancy: Quality of tenant, lease terms, rent level
• Use class: Some property types considered higher risk

Tenant Quality

Lenders prefer:

• Established businesses: Trading history of 3+ years
• Strong financials: Profitable, well-capitalized tenants
• Signed leases: Existing tenancy in place
• Appropriate use: Tenant's business matches property type

Types of Commercial Mortgages

Owner-Occupied Commercial Mortgages

For businesses buying premises they'll operate from:

• Higher LTV available (up to 75%)
• Business accounts and forecasts required
• Business must demonstrate ability to afford repayments
• Personal guarantees usually required

Commercial Investment Mortgages

For investors buying property to rent:

• Focus on rental income and property value
• Lower LTV (65-70% typical)
• Assessed primarily on rental coverage
• Multiple properties can build a commercial portfolio

Semi-Commercial Mortgages

For mixed-use properties (e.g., shop with flat above):

• Specialized products required
• Fewer lenders available
• Assessment considers both residential and commercial elements
• Typically 70-75% LTV

Auction Finance

For commercial properties bought at auction:

• Fast completion required (28 days)
• Often structured as bridging loan initially
• Refinance to term mortgage after completion
• More expensive short-term but provides necessary speed

The Application Process

1. Property Identification

Find a suitable commercial property:

• Strong location
• Good tenant in place (or strong letting potential)
• Appropriate price for realistic rental yield
• Property type lenders will finance

2. Initial Financial Assessment

Before making an offer, verify affordability:

• Calculate required deposit
• Estimate mortgage payments
• Confirm rental income meets DSCR requirements
• Factor in all costs

3. Engage Professional Team

Commercial mortgage broker: Essential for accessing suitable lenders Solicitor: Experienced in commercial property transactions Surveyor: Commercial property surveyor for valuation and survey Accountant: For financial advice and structure planning

4. Make an Offer

Subject to:

• Finance approval
• Satisfactory survey
• Legal due diligence
• Review of tenancy agreements

5. Mortgage Application

Your broker submits applications to suitable lenders with:

• Personal financial information
• Property details
• Rental information and lease documentation
• Business plan (if owner-occupied)

6. Valuation

Lender arranges professional valuation (at your cost, typically £500-£2,000+).

Valuer considers:

• Property condition and location
• Current rental income
• Market rental values
• Comparable sales
• Investment yield

7. Legal Due Diligence

Solicitors conduct:

• Title searches
• Environmental searches
• Planning and building regulation checks
• Lease review
• Tenant reference checks

8. Mortgage Offer

If valuation and legal checks are satisfactory, lender issues formal offer.

9. Completion

Funds transfer, property ownership transfers, tenancy continues.

Structuring Your Purchase

Personal vs Limited Company

Many commercial investors use limited companies:

Advantages:

• Corporation tax (19%) lower than higher-rate income tax
• Limited liability protection
• Professional image
• Easier to involve partners
• More efficient for building a portfolio

Disadvantages:

• Additional administrative burden
• Accountancy costs
• May restrict some lender options
• Extracting profits incurs additional tax

Loan Structures

Interest-only: Lowest monthly payments, maximize cash flow Repayment: Build equity over time, reduce risk Part-and-part: Combination of both approaches

Costs to Budget For

Purchase Costs

Deposit: 25-35% of purchase price Stamp Duty: Higher rates than residential

• 0% on first £150,000
• 2% on £150,001-£250,000
• 5% on £250,001+
• Additional 3% surcharge if you own other property

Legal fees: £1,500-£5,000+ Survey/valuation: £500-£2,000+ Broker fees: Typically lender-paid Mortgage arrangement fees: 1-2% of loan amount

Ongoing Costs

Mortgage payments: Based on loan and rate Maintenance: If not FRI lease Insurance: Buildings insurance (contents if applicable) Management: If using letting agent (10-15%) Service charges: If leasehold or shared facilities Ground rent: If leasehold Accountancy: £500-£2,000+ annually if using limited company

Example Deal Analysis

Property: Retail unit Purchase price: £350,000 Deposit (30%): £105,000 Mortgage (70%): £245,000 Interest rate: 5.5% interest-only Annual rent: £28,000 Lease: 10 years, FRI, 5-year rent reviews

Annual Income: £28,000

Annual Costs:

• Mortgage interest: £13,475
• Management (10%): £2,800
• Accountancy: £1,000
• Insurance: £500
• Contingency: £1,000 Total costs: £18,775

Annual profit: £28,000 - £18,775 = £9,225 Net yield: £9,225 / £105,000 = 8.79% return on investment Gross yield: £28,000 / £350,000 = 8% DSCR: £28,000 / £13,475 = 2.08 (excellent)

Risk Factors to Consider

Tenant Risk

• Business failure leading to void periods
• Tenant disputes or non-payment
• Sector-specific risks (e.g., retail challenges)

Property Risk

• Obsolescence of building or location
• Major repair requirements
• Planning changes affecting use

Market Risk

• Rental value decreases
• Property value falls
• Interest rate increases

Mitigating Risks

• Choose strong locations
• Invest in established, profitable tenants
• Maintain adequate cash reserves
• Fix interest rates for stability
• Obtain comprehensive insurance
• Conduct thorough due diligence

Tips for First-Time Commercial Investors

Start small: Don't overstretch on your first deal Choose quality locations: Prime locations recover better from downturns Focus on rental yield: Capital growth is secondary to income Understand the lease: Read and understand all lease terms Build professional relationships: Good team members are invaluable Keep reserves: Have 6-12 months' costs in reserve Consider single-let initially: Multi-let properties are more complex Research thoroughly: Understand the local market and tenant sector

Conclusion

Commercial property investment can provide excellent returns, stable income, and portfolio diversification. Success requires understanding the different metrics lenders use, securing appropriate finance, conducting thorough due diligence, and choosing the right property and tenant.

While commercial mortgages are more complex than residential, with the right professional advice and careful planning, your first commercial property deal can be the foundation of a profitable investment portfolio.

Working with an experienced commercial mortgage broker ensures you access suitable lenders, understand all requirements, and structure your deal optimally from the outset.