Pardon the pun, but the fact remains that we are living in a time of historically low interest rates. Given interest rates’ profound effect on the commercial real estate market, this topic is worthy of discussion. I once had a real estate professor say that the best way to send him reeling was to tell him where you think interest rates are going to be at some point in the future. “No one can predict interest rates with any level of accuracy!” he professed. “Least of all real estate investors.”
At that time the 10-year Treasury was trading at near historically low yields of 2.5%, leaving many to believe that rates had nowhere to go but up. Within 18 months the 10-year would dip below 1.4%. To further punctuate the unpredictability of interest rates, a Bloomberg survey of 43 economists last year forecasted the 10-Year treasury would be trading at a 3.5% yield by now. If even these professional economists can so erroneously miss the mark, it would be silly for most of us to believe that we could do any better. While the Federal Reserve has at least given us some indication, pledging to keep interest rates low through late 2014, they are by no means beholden to that commitment.
Since real estate investors often finance their assets with upwards of 85% debt capital, the cash flow available to them after servicing their debt can be highly sensitive to those rates. Floating rate debt can quickly erode excess cash flow in an environment in which interest rates are rising, especially on highly leveraged assets. Without offsetting rent growth, a 200 basis point increase in the interest rate on your mortgage could easily cost you 30% to 50% of your cash flow after debt service and potentially push your debt-service-coverage ratio below loan covenants, thus putting you in default. Yikes!
Although one cannot project market interest rates with any degree of certainty, borrowers can still manage their interest rate risk by utilizing a multitude of interest rate management options available in the marketplace.
Fixed-Rate Loans – The simplest way a borrower can manage his interest rate risk is with a fixed-rate loan. Of course, obtaining a fixed-rate loan is not without a price. First, fixed-interest rates are often 150 to 200 basis points higher than floating rates, which, as demonstrated above, can have a significant effect on property cash flow. Second, while a fixed-rate can keep your mortgage payment low while interest rates are rising, you may find yourself locked in to an above-market rate when interest rates are falling.
Interest Rate Swaps – Borrowers have the option of exchanging their floating interest rate payment obligation for a fixed interest rate obligation – for a premium, of course. Ten-year interest rate swaps are currently 1.8%, meaning that to lock in a fixed-rate you will be required to pay a 1.8% premium over your current floating interest rate. However, just like in a fixed-rate loan, by engaging in an interest-rate swap, you forego the benefit of lower floating rates if market interest rates remain below the swap’s fixed rate. Furthermore, if your swap is terminated before its stated maturity date, you may owe an early termination fee.
Interest Rate Caps – Interest rate caps mitigate the opportunity cost of fixed-rate loans: you can enjoy your current, low floating-rate, and if interest rates rise, your rate will only rise up to a pre-determined level (a “cap”). Just like swaps, caps are not without a cost. Borrowers who wish to cap their interest rates must pay an up-front cost to do so. These costs can be substantial and will vary depending on where the borrower wishes to cap their rate – the further the cap strike rate is from current market rates, the less expensive.
Today, many investors are choosing to take out floating-rate loans to take advantage of historically low interest rates and are not utilizing any rate-management tools under the assumption that interest rates will continue to stay low for the foreseeable future. While somewhat risky, this is not an unfounded assumption: Treasury and forward LIBOR yield curves are still relatively flat, and you would be hard-pressed to find many economists projecting any explosive economic growth in the foreseeable future.
There is no one-size-fits-all interest rate management strategy. Each investment is unique, and the optimal strategy will depend on a number of factors including: loan-to-value, product type, pro forma, net operating income, growth, and equity partner/guarantor preferences. Over our twenty year history, Metropolitan Capital Advisors (“MCA”) has gained the experience necessary to advise our clients on the best interest rate management strategies. We take every relevant factor into consideration when advising our clients on which strategy is optimal for their unique situation.
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