Why ZIRP Is Building Up Real Estate Risk At Banks [Calculator]

Limiting Commercial Real Estate (CRE) Risk At Banks

There is many ways the current interest rate environment is impacting banks.  The balance sheets of community banks, for instance, are very sensitive to short-term interest rates. Short-term rates drive the cost of funding, loan and securities yields. These factors, in turn, impact a bank’s return on assets and equity valuation.  However, one the largest and most concerning effect is how the Federal Reserve’s ZIRP (zero interest rate policy) is causing an insidious buildup of CRE credit risk – risk that is being generated by property price distortions and asset price bubbles. In this post, we explore the credit risk spring that is being wound by ZIRP and what banks can do to avoid this risk by using a few simple lending principles. At the end of this post, be sure to download our free stress test calculator so you can run your analysis on your loans.

The Risk

Consider the graph below which shows the national average cap rates on commercial real estate.  The current cap rate level of just under 7.75%, lower than the cap rate reached before the last recession.  Artificially low-interest rates for so long have made financing cheap and real estate very expensive based on cash flow discount methods.  What that means for lenders is that any increase in the cap rate results in decrease real estate valuation and higher loss rates on loans.

National Average Commercial Real Estate Cap Rates

Commercial Real Estate Cap Rates

Sensitivity Analysis

To demonstrate the risks of interest rates on real estate credit, we built a simple calculator where a banker inputs the following information: collateral value, loan interest rate, loan-to-value (LTV), loan amortization, term, and capitalization rate.  The model will output the following: net operating income (NOI), leverage ratio, debt service coverage (DSC) ratio, and sensitivity analysis (DSC at 3.00% up, and amount of interest rate increase required to break 1.2x DSC). 

A sample run appears in the output below.

Commercial Real Estate Rate Shock Calculator

Key Findings

Consider this CRE loan: 1.27x DSC; 75% LTV (the industry average for community banks is approximately 73.8% for CRE loans above $1mm, but the ranges are quite broad); 7% cap rate (the current average for major US metro areas); with 20-year amortization and a 4.0% interest rate.  Not only does this loan appear to be bankable, but it is also a typical structure for many community banks.  However, this loan hides substantial credit risk.

Our model demonstrates this with a + 3.00% rate shock in interest rates. Under this scenario, the debt service coverage ratio falls to an impaired 0.99x.  Another way to look at this is that it only takes a 62bps movement in rate for this loan to fall below 1.20x DSC, or a bank’s typical policy guideline. In addition to pure credit risk, this also presents material liquidity or refinancing risk. 

The graph below shows the relationship between rising interest rates and the DSC ratio for our sample loan.

CRE Loan Rate Shock

 Further, when cap rates adjust from 7.00% to 8.00%, the LTV jumps to 85% (assuming no increase in NOI).  Should cap rates revert to the mean of 9.00%, the LTV jumps to 96%, or again, outside of most bank’s policy. 

The graph below shows the relationship between cap rates and LTV for our sample loan.


CRE LTV Rate Shock


Of course, the triple whammy that is most concerning in our analysis is that when interest rates rise, cap rates follow, and borrower NOI decreases – the three factors are positively correlated. This is not only a possible future scenario but a probable one.  With just a 10% decrease in NOI, a 1% increase in cap rates and 1% increase in interest rates (all changes are within one standard deviation), the loan shows a 1.05 DSC and 95% LTV. This obviously means potentially higher reserves, more time monitoring, a higher expenditure of resources and a higher cost of capital.

Alternatives for Community Banks

So what should banks be looking for in their next credit? 

The easy answer is to start to move up in credit quality which is a tactic that CenterState is employing. Find a borrower who wants 60% LTV, on a higher cap rate category (such as industrial).  Those loans do exist, but the downside tradeoff is that the credit spread for those loans is substantially lower and a five-year fixed rate for such credit will be competitively priced at 3.125%.  Banks will lament about the yield and the net interest income, however, after adjusting for risk, the lower priced loan will show a higher risk-adjusted return on capital than our sample loan above.


As we wrap up, we want to emphasize that above point one more time as it will be the difference between failure and survival for most banks at our next downturn – Banks should not be concerned with the current net interest margin, but with the expected risk-adjusted return over the life of the loan.

If you think rates are not going to move up for the next five to ten years or at least the economy is going to strengthen at a faster pace than rates will be moving up, then ignore this post. However, ignore this post at your peril.

We don’t believe this is 2007 all over again, but it is highly likely we are nearing 2004.

The time to take risk and go for borrowers that will pay a higher credit premium is likely past. The time to put more risk on the balance sheet was early in the credit cycle when property values were down, cap rates high and interest rates were going down.

A long period of low-interest rates has created major market distortions (or asset bubbles) in many markets for many property types. The current real estate cap rates and low-interest rates are creating a profound credit risk for the banking industry, and we see many banks falling into this trap. The solution for banks that want to maintain long-term viability and profitability is to seek loans with better credit quality (lower LTVs, higher cap, and greater cash flow) and give up net interest margin to do it.  

While painful at the moment, such a strategy will ensure the bank’s survival in the long term.

If you want to get a better feel for the interplay between interest rates, cap rates, DSC and LTV, you can download our simple Excel model HERE.