Interest Rate Reality Check: What CRE investors should consider with rising rates
After interest rates fell to historic lows amid the COVID-19 pandemic, inflation and geopolitical turmoil have taken hold, and rates have reversed course quickly, climbing back closer to historic averages.
The 10-year U.S. Treasury, a common barometer of interest rates, mortgage rates and overall investor sentiment and risk, fell to roughly 0.50% in July 2020, an unthinkable level given the rate was above 3.00% less than 2 years earlier. During times of tumult, investors flee towards safe haven investments such as U.S. Treasuries, and this demand causes bond prices to rise. Bond yields move inversely to bond prices so as investor demand drives up bond prices, interest rates fall just as they did in early 2020 as the pandemic set in. The speed at which rates fell was unprecedented, highlighting the risk investors saw in the global economy.
After sinking to historic lows, the rate has jumped back above 2.35% as I write this article, back above levels seen prior to the pandemic and we are clearly seeing the impact on mortgage rates.
Investors were able to obtain rates in the 2s and 3s amid the darkest days of the pandemic. Lenders, however, started instituting rate floors to protect themselves from potential unexpected upswings in rates. Well, we’ve seen these upswings take shape over the past several months, and lenders have been increasing their rates back to more normal levels to reflect where market rates are heading.
We’ll now take at how increased interest rates can impact investors and their cash flow.
Let’s take a $10 million loan at 3.50% amortized over 30 years. The total annual debt service is roughly $538,854. The loan constant here is 5.39%. Putting principal pay down aside, provided the cap rate or income on the property is above the loan constant, the cheaper debt relative to property income will enhance an investor’s cash flow and returns. We call this positive leverage.
Now, with rates increasing, let’s say the lender has increased their rate from 3.50% to 4.50%. Assuming the same $10 million loan amount and 30-year amortization, the new annual debt service is $608,022 and the loan constant is 6.08%. This 1.00% increase in interest rate has increased debt service by $69,169 or roughly 13% per year.
This 1.00% interest rate increase may seem steep, however, the 10-year has risen back above pre-pandemic levels, and the general sentiment is rates are still “low” and will be increasing further over the next several quarters as the Fed has already started raising rates and additional increases are being baked into the market.
This means (1) the cost of debt will increase, (2) investors will feel a strain on cash flow, (3) deals that penciled at lower cap rates may no longer meet investor’s criteria and (4) the increased cost of debt may force lenders to lower their loan-to value ratios (LTVs) given the higher debt service’s impact on meeting minimum debt service coverage ratio (DSCR) levels. There could also be a potential negative impact on asset valuations as the higher priced debt may force buyers to the sidelines, reducing investor appetite for new acquisitions.
One way to help find the lowest rate (and best overall structure) is to speak with several lenders and find the best deal.
Hint, the StackSouce platform can connect you with multiple lenders without any added legwork.