How Interest Rate Changes Affect Commercial Property Finance

The Relationship Between Base Rate and Commercial Property

Interest rates are the single most powerful external force acting on the commercial property market. When the Bank of England changes the base rate, the effects ripple through every aspect of property finance - from [commercial mortgage](/services/commercial-mortgages) pricing and property valuations to development viability and investment strategy.

The dramatic rate cycle of 2022-2024, which saw the base rate rise from 0.1% to 5.25% in just 20 months, provided a stark demonstration of this relationship. Property values fell, transaction volumes collapsed, and borrowers faced substantially higher debt costs.

Understanding how rate changes affect your property investments and financing allows you to make better decisions about acquisitions, refinancing, and portfolio management.

How Base Rate Affects Commercial Mortgage Pricing

The Mechanics

Commercial mortgage rates are composed of two elements:

**Rate = Reference Rate + Lender Margin**

The **reference rate** is typically one of:

• Bank of England Base Rate (for variable rate products)
• SONIA (Sterling Overnight Index Average) - the replacement for LIBOR
• SONIA swap rates (for fixed rate products) - reflecting the market's expectation of future SONIA rates

The **lender margin** (also called the spread or credit margin) reflects:

• The lender's cost of funding
• The risk profile of the loan (LTV, asset quality, borrower strength)
• The lender's profit margin
• Market competition

Variable Rate Products

Variable rate commercial mortgages move in near-lockstep with the base rate. A 0.25% base rate cut translates directly to a 0.25% reduction in the borrower's interest rate.

For a borrower with a £1,000,000 commercial mortgage on a variable rate:

• Base rate cut of 0.25% = annual interest saving of £2,500
• Base rate cut of 1.00% = annual interest saving of £10,000

Fixed Rate Products

Fixed rate commercial mortgages are priced off **swap rates**, not the base rate directly. Swap rates reflect the market's expectation of where rates will be over the fixed term. This creates an important distinction:

• Fixed rates often move before the Bank of England actually changes the base rate, as swap markets price in expected rate changes
• A well-timed fix can lock in rates below the current base rate if the market expects cuts
• Conversely, swap rates can rise above the base rate if the market expects future rate increases

**Key Takeaway:** If you expect rates to fall, fixing now may not be optimal because swap rates may already reflect expected cuts. If you expect rates to rise (or uncertainty), fixing provides certainty even at a premium to variable rates.

How Rate Changes Affect Property Values

The Yield Relationship

Commercial property values are primarily determined by **investment yields**:

**Property Value = Net Rental Income / Yield**

Yields are influenced by many factors, but interest rates are significant because they affect:

• The risk-free rate - property yields must offer a premium over government bonds
• Borrowing costs - higher rates increase the cost of leverage, reducing demand from leveraged buyers
• Alternative investments - higher rates make bonds and savings accounts more competitive with property

The Transmission Mechanism

When interest rates rise:

1. Borrowing costs increase - leveraged investors can afford to pay less for assets
2. Risk-free returns increase - the yield premium property must offer widens
3. Transaction volumes fall - buyer-seller pricing gaps widen
4. Yields move outward (values fall) - to maintain the risk premium
5. Development viability reduces - higher finance costs squeeze margins

When interest rates fall, the process reverses:

1. Borrowing costs decrease - leveraged investors can afford to pay more
2. Risk-free returns decrease - property's yield premium looks more attractive
3. Transaction volumes increase - capital flows into property
4. Yields compress (values rise) - competition drives prices up
5. Development viability improves - lower finance costs enhance margins

The 2022-2024 Experience

The rapid rate rise cycle demonstrated this mechanism dramatically:

• Industrial yields moved from approximately 3.5% to 5.0% (values fell approximately 30%)
• Office yields moved from approximately 4.0% to 6.0%+ (values fell 30-40%)
• Retail yields were already elevated but moved further out in weaker locations

Capital values fell across most sectors, with the degree of decline reflecting both the rate change and sector-specific factors.

Impact on Existing Borrowers

Variable Rate Borrowers

Borrowers on variable rate commercial mortgages feel rate changes immediately:

• Rate rises increase monthly payments, potentially squeezing cash flow
• Rate cuts reduce payments, improving cash flow and profitability

**Interest Cover Ratio (ICR)** is a critical metric. Lenders typically require rental income to cover interest payments by at least 1.25x to 1.50x. Rising rates can push borrowers below this threshold, triggering:

• Covenant breach - the lender may request additional equity or security
• Refinancing difficulty - if the ICR is too low, other lenders may decline to refinance
• Forced sale - in extreme cases, borrowers may need to sell to repay the debt

Fixed Rate Borrowers

Fixed rate borrowers are protected during the fixed period but face exposure at maturity:

• Borrowers who fixed at low rates (2-3%) in 2020-2021 face a significant rate shock at maturity
• Early repayment charges (ERCs) prevent early exit from fixed rates, even if variable rates become more attractive
• Maturity risk - the rate at renewal may be substantially higher than the original fix

**Key Takeaway:** If your fixed rate commercial mortgage is approaching maturity, start planning your refinance at least 6 months in advance. Rate shock at renewal can be significant, and early preparation gives you time to shop the market for the best terms.

Refinancing in a Changing Rate Environment

When to Refinance

Rate changes create refinancing opportunities and pressures:

**Consider refinancing when:**

• Your current rate is significantly above market rates
• Your fixed rate is approaching maturity
• Rate cuts have made variable rates more attractive than your existing fix
• You want to lock in a new fix at current levels
• Your property value has increased, allowing you to access better LTV-based pricing
• You want to release equity for further investment

**Be cautious about refinancing when:**

• Early repayment charges make the cost prohibitive
• Your property value has fallen, meaning higher LTV and worse pricing
• You expect rates to fall further (waiting may secure a better rate)
• Refinancing costs (legal, valuation, arrangement fees) exceed the interest saving

Fixed vs Variable: The Decision Framework

Choosing between fixed and variable rates depends on your view of the rate cycle:

Market View	Suggested Approach
Rates will fall significantly	Stay variable, benefit from cuts
Rates will fall modestly then stabilise	Fix for 2-3 years at current levels
Rates will remain stable	Fix for 5 years for certainty
Rates will rise	Fix immediately for the longest available term
Uncertain	Consider a tracker with a cap, or fix a portion

Swap Rate Monitoring

Monitoring **SONIA swap rates** gives you insight into where fixed rates are heading:

• 2-year swaps influence 2-year fixed commercial mortgage rates
• 5-year swaps influence 5-year fixed rates
• Swap rates falling = fixed rates likely to improve
• Swap rates rising = fix now before rates increase

Impact on Property Investment Strategy

Yield Spread Analysis

The **yield spread** (gap between property yield and borrowing cost) is a critical measure of investment return from leveraged property:

**Yield Spread = Property Yield - Borrowing Rate**

In the low-rate era (2015-2021), yield spreads were generous:

• Industrial yield 4.5%, borrowing cost 2.5% = 2.0% spread

At rate peaks (2023-2024), spreads compressed or turned negative:

• Industrial yield 5.0%, borrowing cost 7.0% = -2.0% spread (negative leverage)

As rates ease (2025):

• Industrial yield 5.0%, borrowing cost 5.5% = -0.5% spread (still tight)

**Negative leverage** means that borrowing reduces your return rather than enhancing it. In this environment, investors must rely on **rental growth** and **yield compression** to generate returns, rather than leverage alone.

Debt-Free vs Leveraged Returns

In a higher rate environment, the case for **lower leverage or debt-free investment** strengthens:

• Equity investors avoid interest rate risk
• All-cash purchases are more competitive in a market with fewer leveraged buyers
• No refinancing risk at maturity

However, leverage still makes sense when:

• The yield spread is positive (property yield exceeds borrowing cost)
• Rental growth expectations justify the cost of debt
• Tax efficiency from debt interest relief is significant
• The investor wants to diversify across more assets with limited equity

Value-Add and Development Strategy

Higher rates create opportunities for **value-add investors** and developers:

• Distressed sellers forced to trade by refinancing pressures
• Vacant or poorly managed assets available at discounted prices
• Conversion opportunities as offices and retail become uneconomic for their current use
• Development opportunities where land values have adjusted to reflect new build cost realities

**Key Takeaway:** Rate changes do not simply make property cheaper or more expensive - they reshape the opportunity set. In higher rate environments, skill and active management matter more than passive leverage. Focus on assets where you can add value through letting, refurbishment, or change of use.

Hedging Interest Rate Risk

Interest Rate Caps

An **interest rate cap** is a financial product that limits your maximum interest rate while allowing you to benefit from rate falls. The borrower pays a premium for the cap, which acts like insurance against rate rises.

• Premium: Varies based on cap rate, term, and market conditions
• Benefit: Protection against rate rises above the cap level
• Cost: The premium payment (which may be significant in volatile markets)

Interest Rate Swaps

An **interest rate swap** converts a variable rate to a fixed rate (or vice versa). Unlike a cap, a swap locks in a specific rate - you do not benefit from rate falls.

Partial Fixing

Some borrowers fix a **portion of their debt** (e.g., 50-70%) and leave the balance on a variable rate. This provides partial protection against rate rises while retaining some benefit from rate cuts.

Planning for Rate Uncertainty

Regardless of where you think rates are heading, prudent planning includes:

1. Stress-test at +2% - can your investment withstand a 2% rate increase from current levels?
2. Monitor ICR carefully - ensure rental income comfortably covers interest at current and projected rates
3. Plan refinancing early - start the process 6 months before maturity
4. Diversify rate exposure - mix fixed and variable across your portfolio
5. Maintain cash reserves - for unexpected rate moves or void periods
6. Review annually - your rate strategy should evolve as market conditions change

For advice on refinancing or structuring your commercial property finance in the current rate environment, [contact our team](/contact). Use our [commercial mortgage calculator](/calculators/commercial-mortgage) to model different rate scenarios.

Summary

Interest rate changes are a fundamental driver of commercial property values, financing costs, and investment returns. Understanding the mechanics - how base rate feeds through to mortgage pricing, how rates affect yields and values, and how to position your portfolio for different rate scenarios - is essential for every commercial property investor and developer.

The current environment, with rates easing from their peaks but remaining above historical lows, creates both opportunities and challenges. Thoughtful rate strategy, early refinancing planning, and rigorous yield spread analysis will help you navigate the cycle successfully.

*Written by Matt Lenzie, Founder of Commercial Mortgages Broker. Ex-Lloyds Bank & Bank of Scotland.*