Higher Interest Rates | New Tax Laws | Long in this Cycle
Release: May 16, 2018
The Effect of Rising Interest Rates on Commercial Real Estate Lending
The benchmark 10-year U.S. Treasury rate breached 3.00% this week and stands at 3.09% as of this writing. This reflects a doubling of the benchmark rate in effect when Donald Trump was elected just 18 months ago; when it stood at 1.53%. The Federal Reserve continues on a dedicated path to increase short term interest rates by 25 basis points up to 3 more times in 2018. The Prime rate now at 4.75% will soon breach 5.0%.
The result of this rise in rates will be felt across all real estate classes and markets as they translate into higher cap rates (lower valuations); plus higher interest costs for construction and permanent finance. Note: In Texas the softening in values will come during a period of historically high real estate tax burdens assessed on commercial real estate by Texas municipalities.
The rise in rates correlates in raising the valuation metric known as “cap rate” and will directly result in a decline in commercial realty values in all markets. Permanent lenders both insurance company and CMBS interest rates will reflect this trend. Today, insurance company debt is priced with a spread of 120-200 basis points over the 10 YR US Treasury rate; resulting in fixed interest rates of 4.25% to 5.00% for non-recourse loans fixed for 10 years. CMBS/Wall Street rates are higher by 50 basis points. Lenders sense most markets are “long in the up cycle” in valuations and are taking a more conservative approach by reducing their underwritten loan to value ratios to 60-65%. Construction lending likewise has seen and likely will continue to experience reduced loan proceeds as banks lower their “loan to cost ratio” on new projects from prior levels of up to 75% loan to cost to a more common level of 65% or less. This of course means more equity will be required and there is no shortage of preferred equity, Mezz and bridge loan lenders with piles of money to cover this gap at rates of 8-12%. Their rates will be rising as well and this all translates into higher new project construction costs, lower valuations, and likely fewer investment sale transactions.
Lastly, new Federal tax rules add some level of uncertainty to the merchant build model as new projects will now be required hold assets for 3 years to qualify for capital gains treatment. For investors with short term bank debt on stabilized assets it is not too late to act. The opportunity remains to refinance and payoff interim bank debt with a fixed rate loan loan which can be assumed in the future if the asset is sold in a higher interest rate environment. Permanent loans are available for acquisitions, cash-out, or refinance of rising floating rate loans with loan terms for 5- 20 years on well leased assets with amortization of 25 – 30 years.
Please call Texas Realty Capital (512-450-6800) to discuss your financing needs on any commercial real estate project and gladly size the financing of your project or a pending acquisition with an array of best in class financing options.