After years of relatively stable interest rates and appreciating property values, commercial real estate property owners and investors must now navigate higher and more unpredictable costs of capital in the current rising rate environment. Today, real estate borrowers face significant increases — sometimes up to 10 times higher — in the costs of interest-rate caps required by lenders. With an estimated one-third of all commercial property debt in floating-rate loans, many property owners and investors have difficult financial choices to make when purchasing or refinancing properties.
Floating-rate debt is an appealing option for property owners because it typically costs less over time and offers more flexibility to sell or refinance the property. When interest rates are lower, interest-rate caps provide a hedge against the impact of interest rate increases. In 2022, these types of hedges saved property owners millions as interest rates increased. But, as the interest-rate cap contracts with lenders expire, rebuying the cap based on higher interest rates comes with a much higher price tag.
Interest rate swaps offer an alternative way to hedge against higher interest rates. Instead of a cap, commercial real estate borrowers can opt to move from a variable floating rate to a fixed rate. With an interest rate swap, the borrower pays the variable interest payment on the loan as well as an additional fixed payment based on the swap rate. Then, the lender rebates the variable rate amount, enabling the borrower to pay a fixed rate. Opting for a swap to lock in a fixed rate can be a smart move when interest rates continue to rise. However, if rates go down, the borrower ends up paying more.
For investors, higher hedging costs can quickly exceed the rental income being generated by a property. This is especially true when tenants are locked into long-term leases. As a result, property owners are exploring their financing options. At one extreme, if property owners don’t have the liquidity to absorb the higher costs of the required interest rate hedges, they may be forced to sell the property or reduce their investments in new properties. Before making that choice, there may be other financing options available, depending on the borrower’s appetite for risk and perceptions about where the market is heading.
Options for Managing Increased Hedging Costs
The last time most real estate borrowers had to weigh concerns about high interest rates and risk tolerance was during the Great Recession. Even with indications that interest rate increases may be easing, rates are not projected to go down in the near future. So, property owners and investors are refamiliarizing themselves with other options available to help manage their debt service, including:
1. Partial Hedge
One way to reduce the cost of rate cap insurance is to hedge only a portion of the debt service. For example, a borrower could choose to implement an interest rate swap for half of the payment cost. This can be an appealing short-term option, especially if signals in the market indicate that interest rates will decrease.
2. Shortened Timeframes
The duration of the cap directly impacts the cost. Typically, rate cap contracts for commercial real estate loans are two to five years. Longer periods increase the cost because the risk is greater due to the uncertainty of the market over the extended timeframe. To address costs in the short term, borrowers can opt for shorter timeframes. The risk is that interest rates will continue to rise, making costs prohibitively high at the end of the contract, forcing the buyer to refinance or sell.
3. Increased Equity
If it’s an option, investors may create a lower loan-to-value (LTV) ratio by increasing their equity. The LTV ratio is a percentage indicating the borrower’s debt relative to the property’s collateral value. If the lender’s LTV is at 70%, the borrower could choose to take only 50% if there’s enough equity.
As the commercial real estate industry continues to adapt to the new rate environment, the dedicated commercial real estate team at CBIZ can help you explore and optimize your financing options. Explore more commercial real estate resources and connect with a member of our team today.
This article includes input from James McDonald, Managing Director of CBIZ’s Credit Risk Advisory Services. James’ experience in commercial banking, lending and risk governance has helped provide financial solutions for clients in the Fortune 500, middle market and small-to-medium sized businesses both domestically and globally.
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