The UK commercial real estate market relies heavily on debt service coverage ratio (DSCR) loans. These loans use a property’s net operating income to determine the loan amount that can be serviced. As interest rates fluctuate, so does the DSCR threshold lenders use to qualify borrowers.
With the Bank of England (BoE) expected to continue raising rates, investors wonder – will DSCR rates also increase through 2023?
This article examines:
- What DSCR loans are and how their rates work
- Recent historical rates
- Forecasts for UK rate movements
- Potential impacts on commercial real estate
- Key considerations when predicting rate changes
Armed with this information, investors can make informed decisions amid a dynamic UK interest rate environment.
What Are DSCR Loans and How Do Their Rates Work?
DSCR loans are a type of commercial real estate financing that focuses on the property’s debt service coverage ratio (DSCR). This measures the property’s net operating income against its total debt obligations.
The higher the DSCR, the easier it is to service the debt.
Lenders establish a minimum DSCR threshold that borrowers must meet to qualify. This threshold determines the maximum loan amount.
- A property has £100,000 in net operating income
- The lender requires a 1.25 DSCR
- £100,000 / 1.25 = £80,000
- Therefore, the maximum loan amount would be £80,000
The DSCR threshold varies by lender but typically ranges from 1.20 to 1.35. It depends on factors like:
- The property type
- Loan terms
- Economic conditions
DSCR loans often have lower interest rates than other commercial financing options. Why?
Because the income-based structure makes them lower risk for lenders. Borrowers are prequalified based on debt service ability.
However, DSCR interest rates still fluctuate over time like other commercial rates. They are influenced by:
- The Bank of England base rate
- Bond market yields
- General credit market conditions
So when the BoE raises its base rate, DSCR rates tend to eventually follow suit.
What Were Recent UK DSCR Interest Rates in 2022?
UK DSCR rates remained low during the 2010s economic expansion. But they started rising in 2022 as the BoE began increasing its base rate.
In Q3 2022, DSCR rates on 5-10 year loans were:
- 4.25% to 5.00% for top properties and borrowers
- 5.00% to 5.50% for more average borrowers and assets
This compared to average rates of 3.00% to 3.75% in early 2022.
Shorter-term DSCR loans saw even sharper rate increases by Q3:
- 4.75% to 5.25% on 3-year loans
- 5.00% to 5.50% on 1-year loans
So over the first 9 months of 2022, UK DSCR interest rates rose around 1.00% to 1.75% across loan terms.
Key drivers included:
- The BoE raising its base rate from 0.10% to 2.25%
- 10-year UK bond yields rising from 0.97% to 3.49%
- Credit spreads widening due to recession concerns
With the BoE intent on further hikes, how much could DSCR rates increase by end-2023?
What Are Forecasts for UK Interest Rate Movements into 2023?
In October 2022, the BoE forecasted UK base rates rising to around 5.00% by mid-2023.
This outlook considered factors like:
- Bringing inflation back to its 2% target
- The UK’s tight labour market
- High natural gas prices continuing
If the base rate hits 5.00%, expect DSCR interest rates to also rise significantly.
DSCR rates could potentially reach:
- 4.50% to 5.25% on 5-10 year loans
- 5.25% to 5.75% on 3-year loans
- 5.50% to 6.00% on 1-year loans
So by late 2023, average UK DSCR rates may rise 1.00% to 1.75% further from current levels.
This assumes bond yields, credit spreads and other factors also adjust higher.
The BoE faces a difficult balancing act with additional rate hikes. More analysis suggests:
- Aggressive hikes could already push the UK into recession by late 2023.
- But moderating increases may allow inflation to remain too high.
The BoE’s final actions will depend on how economic data unfolds.
How Could Higher UK Interest Rates Impact Commercial Real Estate?
Predictions suggest UK DSCR interest rates could rise 1.00% to 1.75% by late 2023.
What would the impact be on commercial real estate owners, lenders and investors?
For Existing CRE Owners
Higher DSCR rates make refinancing & new purchases more expensive. This may lead owners to:
- Postpone refinancing if possible
- Seek longer loan terms to spread costs
- Make debt reduction a priority
- Focus on raising in-place rents
For CRE Lenders
As rates rise, lenders may:
- Further tighten their DSCR requirements
- Shorten maximum loan terms
- Avoid financing marginal assets & borrowers
- Increase credit monitoring of existing loans
Rising default risk could also limit lenders’ profit margins.
For CRE Equity Investors
Investors may see:
- Lower yields on new acquisitions
- Delayed expected refinancing gains
- Reduced property appreciation potential
This can alter target return thresholds and influence capital allocation decisions.
In summary, all real estate participants should stress test their strategies for a significantly higher rate environment. Adjustments to debt use, underwriting and business plans may be required.
Key Considerations When Forecasting UK Interest Rate Movements
Predicting UK DSCR rate changes requires monitoring several macroeconomic factors:
Bank of England Base Rate Outlook
As the benchmark for interbank lending, BoE moves directly influence DSCR loan pricing. Track its rate forecasts and policy committee guidance.
Government Bond Yields
Treasury yields are a bellwether for long-term rates. Rising yields typically foreshadow higher DSCR loan rates.
UK Inflation Data
Surging consumer prices may force the BoE to raise rates faster than desired. Conversely, declining inflation allows more gradual hikes.
Labour Market Trends
With unemployment near historic lows, the BoE is wary of excessive wage growth fueling inflation. A weakening labour market could change its calculus.
Cross-currents like the Russia-Ukraine war, supply chain woes, and China’s economic slowdown all weigh on UK monetary policy.
In addition to economic indicators, regularly follow DSCR rate trends and expert forecasts from lender groups, research firms, regulators, and leading publications.
No one can predict exactly how high UK interest rates will go through 2023. But arming yourself with DSCR loan knowledge and monitoring key rate drivers gives investors the best opportunity to make informed financing decisions amid fluid market conditions.
The UK real estate industry has weathered past cycles of rising and falling interest rates. While higher DSCR costs present new challenges, they often bring new opportunities as well. Maintaining perspective and adaptability will be key to navigating the road ahead successfully.