A Rising Interest Rate Environment
Implications for Financing Real Estate
For this month’s blog post, we wanted to address the affordability of debt and what a rising interest rate environment means from a borrower’s perspective. We’ve had many discussions recently with borrowers who are surprised when lender term sheets are returned with loan amounts lower than expected.
“My covenant is strong, I have credit history with this lender, so why is the LTV so low?”
“This is a stable, cash-flowing asset that’s fully repositioned and I’m a strong borrower – why is LTV topping out at 65% on 1st mortgage take-out financing?”
“Why is the lender being so aggressive stabilizing NOI? This is dramatically reducing value from stated NOI.”
These are the types of questions we’ve been fielding more and more lately, so we wanted to address the situation in a bit more detail here.
Over the past many years, seeing loan-to-value’s (LTV’s) upwards of 75% on term-reducing 1st mortgages or 85% (and higher) interest-only debt for acquisition/repositioning/construction wasn’t unusual; in fact, it was the norm and even a reliable metric to use when building pro forma’s. However, given what’s happened recently with interest rates (and bond rates in Canada and the US) and lenders’ requirement to stress-test debt service capabilities at higher interest rates, LTV has become more a resulting value than a target. The real issue is whether or not, in 3-5 years (the typical mortgage term), a lender is comfortable that a borrower’s asset will be positioned properly to repay the outstanding principal on his or her debt. In the recent past, at such low interest rates, leverage and debt-service coverage cooperated. Now, with interest rates creeping upwards, meeting minimum debt service coverage ratios (DSCR) is the issue. Further compounding this is rising interest rates will likely depress asset prices by the time a mortgage matures.
Let’s take a step back. We’ve all enjoyed the unprecedented low interest rate environment for some time now. Debt in general has been exceptionally cheap over the last many years with residential mortgages, commercial mortgages, car loans (the list goes on) all being incredibly affordable. Interest costs have been mostly a mild nuisance versus a serious consideration when it comes to servicing debt. Why? Well, we can first look to the US-led financial crisis of 2008-2009 which created recessionary periods for both the Canadian and US economies. Secondly, with the pain felt much closer to home, consider oil prices falling out the bottom of the barrel starting in 2014. As a result, in efforts to stimulate struggling economies, both the US Fed and the Bank of Canada (“BOC”) kept the policy rates at historic lows over quite an extended period of time. Depending on the perspective one takes, interest rate increases may be a good news story. However, from a real estate investor’s perspective, it appears that the interest rate honeymoon is over. We’ve all read the headlines regarding the BOC following the US Fed’s lead by raising interest rates relatively quickly in a short period of time. With a 50bps increase to the overnight lending rate occurring in the latter part of 2017 (25bps in July and 25bps in September), followed quickly by another quarter point increase in January of this year, it seems the BOC is following the US-trend of increasing interest rates to curb inflation fears and cool what’s perceived to be overly aggressive growth.
Understanding that more rate increases are very likely going to be coming down the line over the next 12-24 months, from a real estate investor’s perspective, what does that mean? The answer is really two-fold. First, on the short-term mezzanine debt side (acquisition, repositioning, construction financing etc), minimum DSCR is typically 1.10 – 1.25. Now, with lenders stress-testing the projected take-out financing 2-5 years down the road at higher interest rates, the ability for a borrower to achieve take-out financing at a high enough LTV is reduced (again, limited by DSCR at reduced cashflow from higher interest rates). This means initial loan amounts will be clawed back to the point that even under stressed conditions, there will be enough principal paydown or value accretion in the property to take-out the mezz financing in place.
Secondly, for stabilized properties where borrowers are seeking either new traditional long-term amortizing debt or renewing existing debt, with higher interest rates, the ability to cashflow a property decreases thus decreasing the DSCR and decreasing the overall loan relative to value. In both scenarios, more borrower equity may be required, even in the scenario of a loan renewal if the higher interest rates impinge DSCR to the point that an equity injection is required to make up the shortfall.
To help conceptualize the discussion above, below is a simple table indicating how a swing in interest rates (and by historical correlation, cap rates following suit) can impact the affordability of debt, and what the implications may be for a borrower come loan maturity.
Beyond the financial serviceability discussion related to leverage and DSCR, a third point mentioned briefly above relates to market capitalization rates. Typically, cap rates follow interest rates, so there may come a time when properties are devaluing relative to acquisition or previous values simply from cap rate increases. Consider this the third risk to a rising interest rate environment. This is really not the time to be over-leveraged (but let’s be honest, is there such a time?).
As shown above, at the maturity of the initial 5-year mortgage term, the Borrower is required to inject additional equity to roll the debt into a new term. Please note that to demonstrate the point, the above example makes assumptions as to cap rate and interest rate increases over 5-years, and it does not consider an increase to NOI through rental revenue increases. However, an increase to NOI would be the sole mitigating factor in the event rates continue to increase.
What the overall rising interest rate environment does is effectively reduce borrowing power, reduce real estate affordability, and make it harder to roll equity from one property to another. Risk averse number crunchers may suggest that this type of credit calming environment is a good thing for the market and the economy. Real estate investors may suggest otherwise! Hedging against a rising interest rate environment is something that must be factored early in any financial model, especially today with the noises from the BOC and what we’re seeing from our neighbours to the South.
One last comment: this entire article is focused on the potential devaluation of real estate compounded with more expensive debt should interest rates continue to rise. With the recent cooling of the Toronto real estate market, BC’s efforts to limit foreign investment, the concerns about the viability of getting Alberta oil out of the province, the ever-contentious political posturing, and many other macroeconomic factors (including the US seeming to not mind the discount being received per barrel of oil due to Alberta's oil transportation route being bottle-necked by political factors), there is a possibility that interest rates will hold steady and perhaps even retract again in the coming years. We won’t say the “R” word at this point, but given the instability in the market and geopolitical factors, it is a consideration. Regardless of the scenario, one thing is for certain: smart real estate decisions need to be made to survive whatever way the economy swings.
Thank you for reading. At NCMC, we give thought to these factors every day as we help our clients source appropriate financing. Please let us know your thoughts on the article above, and also let us know if you’d like to see a specific topic discussed in the future.