Why Commercial Mortgage Finance Is More Expensive Than Residential
When it comes to financing properties it is something we love doing. One question that often occurs is why there is a disparity in interest rates between commercial mortgages and residential mortgages?
This price discrepancy is rooted in several factors, each contributing to the higher costs associated with commercial mortgage finance.
In this article, we’ll delve into the reasons why commercial mortgage rates are typically higher than those for residential mortgages because there are real reasons behind it. Oh, and if you think the cost is too high then get in touch as we have some great solutions that not everyone provides…
Risk Profile (or, it goes wrong more often)
One of the primary drivers behind the disparity in mortgage interest rates is the difference in risk profiles between commercial and residential properties. Residential properties are typically considered less risky for lenders because they are used for personal housing, and individuals are proven to prioritise their mortgage payments to keep a roof over their heads.
Statistics on default rates prove this.
Commercial properties, on the other hand, can be used for a variety of purposes, including offices, retail spaces, industrial facilities, and more. The income generated from these properties often depends on the success of the businesses operating within them, something 100% outside of the borrowers control.
If a business tenant faces financial difficulties or vacates the property, it can result in higher default rates and increased risk for the lender, leading to higher interest rates to compensate for that risk, and so on and so on.
Loan Size and Complexity (it is never one size fits all)
Commercial properties tend to be larger and more complex than residential ones, requiring larger mortgage loans. These larger loans are often more difficult to underwrite and carry a higher administrative burden for lenders.
The due diligence required for commercial properties is generally more extensive, involving evaluating the business plan, leases, property valuations, and other factors. The increased complexity and cost associated with assessing commercial mortgage applications contribute to the higher interest rates.
There is no ‘standard’ commercial property. If you look at a line of apparently identical commercial units they will all be different internally. There is no ‘3 bed semi’ equivalent.
Market Volatility (think, it’s what nobody can control)
Commercial property markets are subject to more significant fluctuations and volatility than residential markets. Economic downturns, shifts in consumer behaviour, and changes in business trends can all impact the demand for commercial properties.
This is something we are seeing now with a reduction in office space and an increase in warehousing as consumers move to hybrid working and more home shopping. The same applies with different rates for buy to let or holiday lets.
Lenders factor in this increased market risk when setting interest rates for commercial mortgages. The higher uncertainty leads to higher costs for commercial borrowers, something that has proven itself in 2022 and 2023.
Loan Term (when size can matter)
Residential mortgages often come with longer loan terms, typically 25 to 30 years, which spreads the risk for lenders over a more extended period.
In contrast, commercial mortgages usually have shorter terms, often between 5 to 20 years. The shorter loan terms result in higher monthly payments and potentially more frequent refinancing, which can increase the risk for lenders.
To compensate for this shorter lending horizon and the associated risks, lenders charge higher interest rates on commercial mortgages. The caveat here is that this element of cost can be market driven with lenders being more conscious of what their competition is doing. Lenders are akin to supermarket price wars, if one moves then so will the other.
Regulatory Differences (the complicated bit)
Residential mortgages are subject to a more stringent regulatory framework compared to commercial mortgages. The additional regulations and consumer protection measures in place for residential mortgages can reduce the risk for lenders, leading to lower interest rates.
In addition, when banks lend they have to set aside capital to cover that lending. The amount they have to set aside depends on what they are lending for (technically known as Risk Weighted Assets and Liquidity). The lowest capital required is for residential mortgages, it then increases up to commercial mortgages which means lending for this purpose is more expensive for the lender.
There are, of course, lots of factors that influence pricing. Not least the current base rate of interest and competitive market forces.
By Dave Farmer