Question: How do increasing interest rates affect commercial real estate loan activity?
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| Commercial Notes is a periodic publication of articles written by professionals at Eaton Partners, Inc. directed toward answering typically asked questions on the financing, leasing, acquisition, disposition and overall ownership of commercial real estate. |
Answer: Commercial real estate, term loans are offered on both a floating and fixed rate basis, with various hybrid combinations of the two. For the purposes of this article, I will restrict the discussion to fixed rates. Fixed rate commercial loans lock the interest rate for the loan term at a spread (margin) over an underlying index such as US Treasury Bonds or Federal Home Loan Bank rates. The majority of fixed rate commercial loans being originated today and for the last 10 years carry a term of 5-10 years even though their amortization periods are much longer. Commercial interest rates have been at historic lows for a number of years and most investors seeking term loan refinancing for lower interest rate purposes have likely refinanced. Prepayment penalties have hampered some of the refinancing activity, but many borrowers simply paid the penalty as the benefits of the lower interest rate outweighed the cost. Since commercial loans do not typically have a coterminous term and amortization period, there is an outstanding loan balance at the end of the loan term that must be paid back to the lender. Over $250 billion of commercial real estate loans are due to mature within the next 3 years. Refinancing these maturing loans has and will continue to provide an ongoing source of commercial loan activity, without much impact from increasing interest rates.
The component of commercial loan activity that is more sensitive to rising interest rates is the acquisition loan. The acquisition of commercial real estate is driven by various factors including interest rates. Commercial real estate is an alternative investment opportunity that is constantly compared to other investment alternatives such as stocks and bonds. The demand to own commercial real estate in recent years and currently is very strong, driven by the attractive yields and the lackluster performance of the other alternatives. This demand has increased sales prices, putting a squeeze on yield with low interest rates contributing as a subsidy, toward achieving those yields. As interest rates increase, the yields will not be as attractive and if sales prices do not adjust downward to reflect the increase in interest rates, alternative investments may begin to compare more favorably with commercial real estate. Sales price adjustments will take time to reflect the increasing interest rates.
Within the last 30 days, the indices that establish longer term fixed rates of interest have moved upward in excess of 50 basis points or one half of one percent. The impact of this 50 basis points increase has resulted in a jump in interest costs from an average low of 6% to 6.5% or greater. The benchmark 10 year treasury yield surpassed the so called barrier of 5% and many interest rate gurus believe the yield may increase by another 50 basis points during the remainder of this year. Commercial interest rates are still extremely low on a historical basis, and I do not expect the recent increases to have any significant effect on commercial lending for the remainder of the year. However, if interest rates continue to rise beyond 7% and into the 8% range, we may begin to see a slackening of demand if sales prices do not adjust accordingly.
2006 should continue to be a banner year for commercial real estate acquisitions and accompanying financing. The volume may not break the record year for commercial loan funding set in 2005, but all indications are that both lenders and intermediaries are currently experiencing and expecting another great year.
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