Given that rates are poised to move up in 2014, this could negatively impact commercial real estate (“CRE”) loan quality. Fortunately, rising rates create some offsetting forces that could help or hurt underwritten CRE loans. The net impact of these multiple forces is why bankers get paid the big bucks to take the risk. To better understand these forces, we break this down into a quick interest rate risk primer for commercial real estate that we believe every lender should know.
Rising rates usually mean the economy is improving, businesses and households are doing better and rents are going up. Of course expenses are also likely going up, so to hold risk constant, rents have to rise so that net cash flow is increased to the same extent the debt service requirements are. From a probability of default perspective, the equation is simple; if debt service goes up 10% then net cash flow has to rise by the same amount to keep the probability of default equal.
However, that is not the whole story. Rising rates also impact the value of the property, and when rates rise, the capitalization rate ("cap rates") also rises, thereby hurting the property’s value. This impacts the loss given default.
To see this in action, let’s take an office building in suburban Atlanta. Let’s also assume that rates start at 4.50% and go to 5.50% next year. Given the market, that would move cap rates up 50bp. To offset this, that means that net cash flow of the property would have to increase an estimated 1.10% so that the value of the property, and hence the loss given default, would stay constant. Should cap rates rise by 1.5%, then cash flow would have to rise by 2% to keep the loan-to-value the same as when the loan was originated.
If this was a fixed rate loan, no problem, as the borrower’s debt service requirements would stay constant. To the extent that rents rise, expenses are held in check and net cash flow increases faster than the rate needed to keep the property value constant, then credit risk for the bank would decrease.
Note that if the loan was floating, and rates rise, net cash flow would have to rise to offset both the increase in debt service cost AND the lower property valuation. This is why making floating rate loans on commercial real estate is biased to be a losing credit proposition in a rising rate environment. Should rates rise slowly, usually the rents can adjust to offset much of the risk. However, in a fast rising rate environment, the combination of higher expenses, higher debt service coverage and lower relative property values hurt the credit position for the bank.
To the extent the property is highly correlated to the local economy, like a hotel, then usually rents adjust almost as fast as debt service (for a good operator). However, for properties with longer term leases or for lease structures that lack adjustments, this could create a credit issue in a rising rate environment (of course, this works the opposite in a falling rate environment).
We also point out that banks that attempt to solve this problem by going with longer reset periods usually don’t solve this problem and could exacerbate the issue. For example, take a ten year loan where the bank structures five, 2-year pricing resets priced off the Federal Home Loan Advance rate. Since the movement of interest rates are random, this structure can either help or hurt the bank (a conversely the borrower). What happens if interest rate spike, reset higher and then fall so rents are now lower? In this example, credit would be stressed. The term of the reset period is largely irrelevant. If rates rise faster than net cash flow, then a reset up would still create a credit issue. What matters is the margin of the reset, the timing of rising rates, the property's cost profile and how the underlying rents are structured.
When underwriting a CRE loan, lenders want to understand the forces that are impacted by rising rates. First and foremost it is cash flow. Understanding the expense structure of the property and the cash flow sensitivities is helpful. Having a clear picture of the tenants/owners sensitivity to rising rates is central to understanding, as is making sure a clear picture of the lease structure and escalation clauses is also important. Finally, looking at supply and demand considerations in the area for the property type to understand how rising rates will impact property values is equally important for proper credit underwriting. An area with lots of new supply coming on may find rent increases difficult.
Right now, the average cap rate in the Nation is about 6.79% and is projected to go up by 4Q of 2015. In some sectors and markets, such as multifamily and office, where supply is coming on line faster than absorption, cap rate will rise faster. This is the same for retail in many markets where supply is expected to be constant but demand is decreasing. Banks need to take these trends into account to protect their collateral position.
After having a clear understanding of how rising rates impact the net cash flow of the property, the next step is to identify the residual risk. To the extent the bank feels that there is some residual credit risk associated with higher rates, then an additional collateral cushion or reserve fund that will act as a buffer usually does the trick to mitigate the risk. This can be structured as a trigger event within a strong set of loan covenants. Whatever the method, banks should not be shy in identifying the problem before the loan is made and then work with the potential borrower to solve for the risk since it is in each of the parties’ best interest.
Interest rate risk is a zero sum game. Someone is taking the risk and banks should be clear they understand where that risk lies. Rising rates create more than just interest rate risk, and banks having a good working set of tools to handle the credit component of rising rates will come out ahead.
Submitted by Chris Nichols on December 11, 2013