The COVID-19 pandemic that swept across the world in 2020 has had a seismic impact on many aspects of life in the UK, including lending practices. As an investor interested in debt servicing coverage ratio (DSCR) lending, you may be wondering – how has COVID-19 changed DSCR lending in the UK? What do I need to know in this new lending landscape?
This comprehensive guide will walk you through the key changes to be aware of and provide insights into how COVID-19 has shaped DSCR lending for UK investors.
What is DSCR lending? A quick refresher
Before diving into the COVID-related changes, let’s start with a quick refresher on what DSCR lending entails.
DSCR lending refers to loans that are underwritten based on the property’s debt servicing coverage ratio. The DSCR measures the cash flow available to service debt obligations. Essentially, it compares the property’s net operating income to its total debt service.
A higher DSCR indicates a lower risk of default, as it shows the property can cover its debt payments with room to spare. Many commercial real estate lenders have a minimum DSCR requirement of 1.20 or greater to approve financing.
DSCR lending looks at the property’s cash flow alone to determine eligibility. This contrasts with other loan types that rely heavily on the borrower’s credit score and history.
With that refresher in mind, let’s look at how COVID-19 has impacted UK DSCR lending for investors.
How has the UK government responded with new loan programs?
The UK government rolled out several new loan programs and schemes to support businesses during COVID-19. For investors, two key programs to be aware of are the Recovery Loan Scheme and the Coronavirus Business Interruption Loan Scheme (CBILS).
What is the Recovery Loan Scheme?
The Recovery Loan Scheme is a government-guaranteed loan program introduced in April 2021 to help businesses of any size access loans as COVID-19 restrictions ease.
Some key features include:
- Available to businesses of any size, unlike earlier programs that focused on SMEs
- 80% government guarantee on lender losses
- Terms from 3 months up to 6 years
- Max loan size of £10 million per business
One notable change from previous iterations is reduced scrutiny around COVID-19 impact. Most borrowers no longer have to formally confirm they have been negatively affected by the pandemic to qualify.
What is the Coronavirus Business Interruption Loan Scheme (CBILS)?
The CBILS program launched in March 2020 to support SMEs struggling due to COVID-19. CBILS loans have a government guarantee of 80% and no interest or fees charged for the first 12 months.
CBILS lending ran until March 2021 and was replaced by the Recovery Loan Scheme. But some existing CBILS loans can still run their course under their original terms.
How do these loan programs benefit property investors?
The government backing of these loans makes them lower risk and more appealing to lenders. This expands investors’ financing options, as lenders can rely on the government guarantees rather than solely the property’s DSCR.
That said, underwriting standards remain stringent. While beneficial, these programs are not a panacea for all lending challenges. The property must still meet DSCR thresholds and demonstrate consistent, adequate cash flow.
How has the mortgage market adapted in the wake of COVID-19?
Have lending criteria tightened across the board?
When the pandemic first hit, many lenders pulled back and tightened lending criteria due to uncertainty. However, as the economy stabilizes, credit markets are loosening up again.
In May 2022, the Bank of England reported that lenders expected credit availability to increase in Q2 2022, particularly for small and medium enterprises. This extends to property investors, signalling lending conditions are becoming more favourable again.
That said, investors with less experience or smaller portfolios may still find it difficult to secure financing relative to pre-COVID times. Overall lending volumes remain below pre-pandemic levels.
Are lower LTV loans more common?
During the height of the pandemic, high loan-to-value (LTV) loans above 70% LTV became less common. Many lenders focused on lower LTV lending.
According to Mortgage Brain research, 65% LTV lending increased from 26% of all mortgages in 2019 to 46% in 2020. Meanwhile higher LTV loans of 80-85% dropped from 27% to just 7% over the same period.
This shift indicates lenders are still somewhat cautious and looking to decrease risk exposure by limiting high LTV loans. Investors may need to be prepared to provide larger deposits.
Have portfolio lending options expanded?
An emerging trend is growth in portfolio lending, where a lender assesses a borrower’s full range of properties rather than looking at each on a case-by-case basis.
This takes a more holistic view of the investor’s assets and cash flow. According to Paragon, portfolio lending has become more popular during COVID-19 among lenders looking to broaden options for property investors.
For investors with multiple properties, exploring portfolio lending can open up additional funding opportunities. Make sure your broker understands your entire investment portfolio when shopping for loans.
How has corporate debt been impacted by COVID-19?
COVID-19 has also influenced corporate debt and lending arrangements. Government loan schemes have provided a lifeline for many businesses to stay afloat, but also impacted debt profiles.
Have businesses taken on more debt due to COVID-19?
Many businesses have taken on significant new debt during COVID-19 according to UK Finance estimates. Total lending to non-financial UK businesses under government schemes reached £79 billion by March 2021.
Some concerning trends around high corporate debt levels have emerged:
- 1 in 3 mid-sized businesses took on new debt during the pandemic
- 45% of mid-sized businesses fear they may default within a year as government lending schemes wind down
- Corporates now owe £150 billion more than they did pre-pandemic
This surge in corporate debt across the economy could influence lending practices as lenders take on a more cautious stance.
For property investors involved in commercial real estate, it also introduces some uncertainty around tenants’ financial health. Highly leveraged tenants pose a higher risk of missing rent payments.
Are government loans driving down corporate bond yields?
Another impact is that government-backed loan programs are driving down yields on corporate bonds. Firms have used these inexpensive government loans to pay off more expensive debt.
Bloomberg analysis shows the yield on sterling corporate bonds fell to 1.38% in March 2021, the lowest level since records began in 1997.
For investors involved in commercial real estate, lower corporate bond yields suggest firms may have greater cash flow available to make rent payments reliable. But this depends on the financial health of each individual tenant.
What does this mean for CRE investors?
For commercial real estate investors, corporate debt trends are important to factor into tenant risk assessments. Research tenants’ debt profiles and leverage ratios to gauge their ability to make consistent rent payments.
Favour tenants with stronger balance sheets over highly leveraged firms struggling with debt taken on during COVID-19. Also assess each tenant’s specific business trajectory rather than relying on macro debt trends.
How have commercial real estate loan margins changed?
Loan margins are another aspect of UK lending impacted by the COVID-19 shakeup. But contrary to many expectations, margins have been fairly resilient.
Did margins spike due to COVID-19 risk perception?
Initially, many expected lenders to increase margins significantly to compensate for heightened risk and uncertainty. However, this worst case scenario has not fully materialized.
According to research by AEW, after the initial market shock, margins for UK commercial real estate loans returned to pre-COVID levels by Q4 2021. The spike was temporary rather than sustained.
How do UK commercial loan margins compare to Europe?
Compared to the rest of Europe, commercial real estate loan margins remain higher in the UK across the board.
According to AEW, average margins for Q4 2019 before the pandemic hit were:
- UK: 159 bps
- Germany & Netherlands: 105 – 115 bps
- France: 135 bps
Two years later in Q4 2021, UK margins ranged from 165 bps (industrial) to 220 bps (hotels). The margin premium compared to Europe persists.
This suggests lenders still perceive the UK as higher risk. Brexit uncertainty alongside COVID-19 has dampened risk appetite for UK commercial real estate relative to Europe.
What should CRE investors make of current margin trends?
In summary, while margins temporarily spiked early in the pandemic, they have remained largely stable and consistent with pre-COVID benchmarks. This resilience provides stability and reliability for investors seeking CRE loans.
However, UK margin premiums persisting higher than Europe indicates lenders are still somewhat wary of COVID-19 risk factors. Investors may have to accept slightly elevated pricing compared to Continental Europe.
The banks all price risk differently so for any real life application make sure you talk to them directly about up to date pricing.
How have Bank of England policies impacted lending conditions?
The Bank of England has also deployed various monetary policies that indirectly impact CRE lending markets. Two of the most influential changes are:
Did the BoE reduce capital requirements for lenders?
Yes – the Bank reduced capital requirements to free up an extra £190 billion of lending power for banks. This included lowering the “countercyclical capital buffer rate” from 1% to 0%.
Reducing this countercyclical buffer gives banks more flexibility to continue lending through periods of disruption. For property lenders and investors, this helps provide stability and liquidity within credit markets.
According to Bank of England estimates, the reduced capital requirements could support up to £9 billion of CRE lending. This demonstrates how the BoE has indirectly facilitated financing for the property sector.
What about interest rates? How has monetary policy shifted?
The Bank also reduced interest rates to historic lows during the pandemic in an effort to stimulate the economy. The base rate dropped from 0.75% pre-pandemic to an all-time low of 0.1% by March 2020.
Low interest rates make financing property investments more affordable and incentivize lending. This has been crucial for sustaining investment activity through challenging times.
However, the Bank has more recently started raising rates again as of December 2021. This is in response to soaring inflation, with further increases expected through 2022-2023.
Higher interest rates may start to squeeze profit margins for investors relying on debt financing. Factor this into projections for future deals and portfolio performance.
Key takeaways – changes to be aware of
In summary, while DSCR lending fundamentals remain intact, COVID-19 has influenced UK credit markets in some important ways:
- New government-backed loan schemes improve access to financing
- Lenders still cautious with lower LTV loans more common
- Corporate debt levels surged, presenting tenant risks
- Loan margins proved resilient despite early spikes
- Bank policies inject liquidity but higher rates loom
As the post-COVID landscape takes shape, staying current on market shifts is key. Work closely with an experienced broker to navigate the new dynamics and capitalize on emerging opportunities.
With the right financing strategy, DSCR lending can remain a viable investment tool to build and diversify your commercial property portfolio over the long term. But anticipating changes and adapting approaches will be essential.
Hopefully this overview provides a solid grasp of COVID’s impact and equips investors to make informed decisions in today’s rapidly evolving UK lending environment.