Financing Amidst a Climate of Rising Interest Rates

January, 2017

In the wake of the presidential election and on the heels of the Fed's first rate hike in almost a year, many investors are wondering what the future holds for commercial real estate and how it might impact their portfolios. There is no denying that investors have benefitted from nearly a decade of unprecedented monetary policy that has held interest rates below historical norms; the economy has largely recovered, rent growth and occupancies have been strong, debt has been cheap, and values have never been higher. Surely investors had to know these low rates could not last forever, particularly as the economy continued to show steady signs of improvement over time.

In order to prognosticate forward, it is sometimes useful to revisit the past and remind ourselves of how we arrived at the present. The near economic collapse that occurred from 2007-2009 was unusually painful, and a series of historic events led to unprecedented measures and monetary policy by our government and its counterparts around the globe. Starting at the end of 2007 the Federal Reserve began slashing the Federal Funds Rate by 25-100 basis points per session; this continued until December, 2008, when the target fell to a negligible 0.0-0.25%. After bottoming out, the economy began its slow and steady march towards recovery, and the prolonged low interest rate climate that ensued proved beneficial for real estate investors and borrowers. Still, the Fed held rates historically low for an extended period to further stimulate the economy in pursuit of its target goals for employment and price stability.

Starting in 2015 the Federal Reserve began to signal that incremental increases were on the horizon. Federal Reserve Chairwoman Janet Yellen defended the strategy, citing further tightening in the labor market and increased inflationary expectations. Despite this, during the period from 2015-2016 there were only two modest 0.25% rate increases, coming at the end of each consecutive year. Neither increase should have come as a surprise to investors, as both were foreshadowed extensively. In fact, the argument could be made that both were largely priced into the markets before being formally announced. At the time of this writing (12/2016) the Fed Funds Rate stands at 0.5%.

The Fed Funds Rate is likely to continue to move upward, but that is only one component of the borrower's cost of funds, the other is spread. Notably in 2007, the all-in mortgage rate for self-storage assets (those originated via the CMBS market in 2007) averaged approximately 6.00%, when the corresponding Fed Funds rate was between 4.25-4.75%. A sample of CMBS loans originated in 2016 as a comparison had an average coupon of 4.80%, with corresponding Fed Funds Rate at or around 0.25%. For loans maturing in 2017, even with a projected Fed Funds Rate increase, borrowers should find an attractive rate.

Considering none of us have a crystal ball on where rates will end the year, a more constructive approach is to focus on the facts and that which we can control in order to map out a strategic game plan and isolate the variables of uncertainty. Below are some points to consider how the market today is different from the capital constrained recessionary environment and will help to formulate a game plan further insulating yourself from the risks of a rising rate environment.

  • Healthy Lending Environment: Different than the recession, the current lending environment is healthy and favorable for borrowers. In 2009 even the best borrowers had trouble finding debt for even the most seasoned and stable performing assets, because the banks were simply not lending. Today the capital markets are firing on all cylinders and there are many options for borrowers seeking debt. Regulatory pressures, as imposed by such regulations as the Dodd Frank Wall Street Reform, have helped banks stay very disciplined. These regulations have helped to curb over-leveraging by lending institutions.

  • Rates Are Still Low: No matter how you look at it, rates are still historically low. There is never a way to time your loan coming due or acquisition to hit the perfect all-time low rate. For those refinancing 10-year loans originated in 2007, as mentioned earlier, rates will still be attractive. For those completing acquisitions, it may be prudent to run numbers assuming rate movement to ensure the returns are still within expectations.

  • Strong CRE Fundamentals: Commercial real estate fundamentals are more solid this time around, generally speaking. This will resonate with self-storage owners especially, as those privy to the product type know that self-storage rents and occupancies are robust, complemented by proven recession-resistant demand characteristics for the product.

  • Gradual Increases, Not Spikes: Although the Fed has finally made good on its promise to begin raising interest rates, thankfully they have been very forthright in telegraphing their plan. The policy thus far has been to foreshadow these increases giving the market time to absorb the increase. If the economy continues on a path similar to 2016, it should mean that the Fed will gradually raise rates in 2017 as well.

  • Inflation Isn't All Bad: During inflationary periods, property owners benefit from an ability to push rents, resulting in increasing net operating income (NOI). This is only magnified in self-storage; the inherent nature of short-term leasing affords investors the flexibility to quickly and frequently adjust market rates through prudent revenue-management practice. After all, it's the very hybrid nature of commercial real estate that makes it such a compelling investment option, with its steady and bond-like cash flow component, even during economic downturns, as well as an appreciation component that often acts as an inflationary hedge.

Floating Rate Debt

It is hard to talk about rising interest rates without considering the impact on floating rate debt. By nature, the interest rate on floating rate debt is not fixed, as the name implies. The all-in interest rate is calculated by adding a quoted spread (which is typically fixed) to a benchmark index- such as LIBOR, the Prime rate or some short-term U.S. Treasury Bill- which is variable. Thus, floating rate debt provides lenders with protection against rising rates, and meanwhile can increase a borrower's cost of capital as rates go up. When considering new floating rate debt or a floating rate mortgage coming due for refinance, borrowers should consider their all-in rate tolerance. Floating rate debt will often feature a rate floor, which can limit a borrower capturing upside when rates are on the decline. On the other hand, interest rate caps can shield borrowers (at a cost) from increasing benchmark rates. In other words, if a borrower anticipates that rates are on the rise in 2017, it is worth considering purchasing an interest rate cap at a lower strike price; the cost of which will also need to factor into the return. Finally, while floating rate debt is appropriate for some investors, locking into a fixed rate debt product may be a more suitable buffer in the face of rising interest rates.

Construction Loans

Many lenders utilize floating rates on construction loans, and rising rates are a real life example of why stress tests are important to consider when modeling a prospective construction deal. For projects already underway, ideally there is an adequate prefunded interest reserve to cover interest carry before the asset hits break even. For new construction, it is crucial to consider the impact rising rate can have on the profitability of the project. Construction loans are often variable rate products with an initial interest only period, with the variable rate component being the kicker. If a developer was projecting rates to rise by only 10 basis points per year, they would be in for a big surprise if instead rates increased by 25-50 basis points in a year.

Conclusion

As we begin 2017, it is important to be informed. Interest rates are officially on the rise, but we already knew that was coming. The economy is on more solid footing than last time around, values are high, rents and occupancies are strong, and banks have shown more discipline, resulting in less over-leveraging. The truth is that we don't know exactly when the rate hikes will occur; but we do know that barring any significant and unexpected volatility, the Fed intends to continue on the course of gradual increases in pursuit of its target goals of stable prices and maximum employment. In other words, compared to rates in the 6.0% in pre-recession times, there is still some room to move. While borrowers may not be in a position to lock in rates as low as they have been in the last few years, they should still be able to lock in at attractive rates in 2017.

Articles: January 2017

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