Analysts believe it is becoming more and more likely that commercial real estate
loans coming due in the next few years will face a higher rate environment. However, the strengthening economy is expected to offfset near-term investor risk.
Two notable commercial real estate developers and investors support the assessment that property fundamentals are catching up to the valuations created by strong capital flows into the property markets.
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Owen D. Thomas, CEO of Boston Properties, said, "If interest rates go up it’s going to be because the economy is improving and, therefore, demand for real estate will go up and rents will go up.”
Steve Schwarzman, chairman and CEO of The Blackstone Group, also noted in his firm's most recent earnings call that rising interest rates are not necessarily a negative, pointing out that when interest rates rise in tandem with better economic activity, the result is higher cash flows for most properties.
Schwarzman pointed out that, in the years in which interest rates rose during the past 20 years and in each of the following years, real estate values also increased between 4% and 15% on an annualized basis, in both the private and public markets.
“So the premise of investors and their concerns on the real estate side are basically belied by the facts,” he said. “Our business returns benefit from strengthening economic activities.”
CMBS 2.0 Defaults Unlikely
From a term-risk standpoint, CRE loans originated since 2007 appear to be in a fairly strong position because the loans were underwritten in times of distress. At the same time, loans made prior to the Great Recession are coming due at a time when rates are still lower than in 2006 and 2007, according to recent analysis from Fitch Ratings.
“CMBS 2.0 term defaults are unlikely so long as the economy continues to strengthen,” said Huxley Somerville, managing director structured finance at Fitch Ratings. In addition, “should the broader economy reverse direction, any downgrades to CMBS 2.0 loans would be purely a byproduct of the economy’s downturn.”
That’s not to say there are not associated risks, Somerville said, adding there are substantially more variables at play that could determine the ultimate success of CMBS 2.0 loans refinancing.
For instance, “if income growth matches the growth in debt service required by the new mortgage rate environment, the chances of successful refinancing are much better for CMBS 2.0 loans,” said Somerville. “However, an interest-only (IO) loan may require a fall in underwriting standards to refinance on the same metrics but for the higher mortgage rate.”
“Counter-intuitively, the number of IO loans has increased significantly in the past 12 months as mortgage rates have dropped. Making IO loans in a low interest rate environment makes far less sense than making them in a high interest rate environment. In the latter, interest rates have a greater propensity to fall from their highs making a refinance more likely on the same balance. In the former, interest rates can only go higher making the refinance potentially more difficult on the same balance,” Somerville added.
Current Underwriting Appears to Compensate for Risk from Rising Rates
At the same time, in the current low rate environment many loans have been originated with high debt service parameters. If interest rates are higher at refinancing, the new loan may still refinance smoothly because the new debt service, while lower than that in the current loan, is still within the lenders’ guidelines.
One question investors and lenders face is the impact higher interest rates may have on property values and how that corresponds to the future lender’s loan-to-value (LTV) guidelines. As rates rise, typically so too do capitalization (cap) rates. Higher cap rates effectively reduce the value of a property if it continues to generate the same or lower level of income. New loans written for properties in that scenario may still be within the lenders’ debt service guidelines but fall outside the lender’s LTV guidelines.
Marielle Jan de Beur, managing director and head of CMBS and real estate research at Wells Fargo Securities, said it has found that LTV ratios are low enough to withstand significant increases in cap rates even under conservative income growth assumptions.
Similarly, the debt service cushions built into the most recent loans, on average, are sufficient to withstand significant increases in loan coupon rates by maturity.
“On the whole, 2013 vintage underwriting metrics are holding up well. While the average loan coupon of 4.2% is the lowest on record for any CMBS vintage, the [net operating income debt service coverage ratio] ratio of 2.07x is the highest. The average LTV ratio of 62.9% is low by historical standards and is down from 2012,” Jan de Beur said. “Finally, although the proportion of interest-only loans is on the rise, these loans are being made at lower LTV ratios.”
“Our analysis suggests that, on average, current underwriting does in fact compensate for the risk of low interest rates that are embedded in new production loans,” she said.