Why That 5Y Adjustable Rate Loan is a Bad Idea

Commercial Loan Structuring

One of the most common structures in commercial lending is that ten-year commercial loan that is structured as a five-year fixed rate loan with a rate reset at the end of five years. There are two main problems with this loan structure, one having to do with credit and the other having to do with interest rate risk that makes this one of the worst performing loan structures in a rising rate environment for community banks. In this article, we delve into the data to compare two popular loan structures.


Our Data Set


To make the math easy, we pulled 100 multifamily loans originated fairly evenly throughout 2013 that had a ten-year maturity, 20-year amortization, and two five-year resets. The average loan size as $3.2mm, the average fixed rate for the first five years was 4.17%, the average spread at reset was 2.47%, and the average debt service coverage (DSC) was 1.38x.


Problem One – The Credit Impact of Higher Rates.


The average debt service on each loan is $19,679 per month before the reset. The average net operating income at the time of origination was approximately $26,035 per month. The average 2013 projected NOI for 2018 was a 4.0% rental growth rate, but the actual NOI growth rate was 5.8% equating to a current $33,885 of net operating income per loan. Incidentally, while operating costs (largely due to higher labor and service costs) were higher than expected, rental rates were also higher than forecast, and occupancy rates were much higher as turnover was materially lower than expected.


The debt service coverage ratio on this subset of loans was a very healthy 1.70%, or much better than the 1.38x at underwriting. All would be good, except here is the first problem – The loans that remain went from a 4.17% rate to a 5.42% rate.


Debt service is now an average of $21,868 equating to a debt service coverage of 1.55x, or below the previous 1.70% rate.


For comparison, we went back and recalculated what would have been the debt service coverage for this group of loans if we made a ten-year fixed rate loan. What we found is that the debt service is lower during the first five years but better after year four as NOI has risen while debt service expense remains constant. For 2018, while the average loan that remained had 1.55x DSC, had the bank made a ten-year loan, the DSC would have been more than 1.59x resulting in a lower probability of default. 


CRE Loan Performance



Luckily, the past five years have been near-perfect for banks using the ten-year maturity with two, five-year reset structure-style of loan. NOI has risen faster than expected while rates have risen slower than expected. Had inflation kicked up and rates jumped off faster, there could have been more underwriting problems at the reset date.


Problem Two – The Probability of Default


The second major issue with a five-year reset is that the above rate reset occurs right when the marginal probability of default is likely peaking. The highest likelihood of a default for a community bank loan usually occurs between years three and seven with a median of year five. If the economy is doing well, like it is now, and NOI is increasing, then - no problem. However, should the economy slow, or a credit shock occur, then a higher rate reset would exacerbate a bank’s chances for a loan restructure. 


Marginal Probability of Default


Problem Three – The Higher Likelihood of Prepayment


Perhaps the largest potential problem with a five-year reset structure is one that largely goes unnoticed. While we have covered the above two points before, we have not looked at the data on repayments with the five-year structure isolated.


In a rising rate environment, the potential increase in rates prompts borrower to not only refinance but refinance early before the reset. Thus, a material number of loans from the reviewed pool that were originated in 2013, disappeared by 2016. By 2016, more than 34% of the five-year reset loans were repaid, and by 2018, more than 60% were gone. Year three ends up being the year with the fastest speed meaning that the ten-year loan that your bank thinks is originating has a duration and average life less than four.


These faster than anticipated speeds may help a bank’s asset liability position out, but it also could be hit to profitability as a bank that leverage the five-year reset needs to originate almost four times the number of loans that a bank that utilizes a ten-year fixed rate structure. 


Annual CRE Prepayment Speeds


In addition to the threat of rising rates, that improving cash flow that we discussed earlier creates an incentive for both tighter spreads and the need to conduct a cash-out refinance.


Putting This Into Action


The above data is one reason why we utilize our ARC program to create a long-term fixed rate loan for the borrower while providing our bank (and others) the ability to receive a floating rate loan without a derivative on the bank’s balance sheet. One huge advantage is that portability of the structure whereby the borrower can move the fixed rate position to another loan or can roll the rate into a new loan. In both cases, the structure helps keep the loan at the originating bank. 


The past five years has been almost the perfect time for the five-year reset-style loan, and still, it has underperformed. It has lower overall debt service coverage and much faster early repayments when compared to the ten-year fixed rate structure.


If your borrower is considering a reset, consider putting it anywhere other than year five. If they desire a longer-term fixed rate loan, consider a straight ten-year structure to improve your bank’s profitability.