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What MuniMae's Move Tells Us About Risks from Rising Interest Rates

Rising Rates Mean Debt Investors Face Higher Borrowing Costs, but Gradual Rise Not Expected To Derail the Recovery
July 10, 2013
In one of the first tangible signs of the impact that the risks from rising interest rates may pose for debt investors, Municipal Mortgage & Equity (MuniMae) decided to sell its entire fixed rate performing multifamily bond portfolio to Merrill Lynch Portfolio Management Inc.

In the transaction, MuniMae received $79 million in cash. The effective price for the $849 million portfolio was equal to fair value at June 30 and 101% of par value. In addition, the sale eliminated $799 million of debt and preferred equity obligations.

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"We have disclosed for some time that we were concerned about rising interest rates, and this transaction greatly reduces our exposure to rising rates,” said Michael Falcone, MuniMae's CEO. “For a variety of reasons, the buyer is currently better able than we are to own and manage these assets in both a rising and a volatile interest rate environment.”

As part of the deal, Baltimore-based MuniMae is hanging on to about $147 million of nonperforming bonds and bond-related investment.

“We have retained the participating and defaulted bonds because we believe that with these bonds the benefits of our intensive asset management will more than offset the risks associated with rising rates,” Falcone said.

Of the $79 million in cash proceeds, $16 million will be pledged as additional collateral against the company’s new and existing borrowings with Merrill Lynch. MuniMae may use the remaining sale proceeds of $63 million to invest in real estate related investments, including within its asset management business, to seek to purchase the company’s subordinated debt at discounted prices and to repurchase some of the company’s outstanding common shares.

“We believe there are attractive opportunities to redeploy the capital we have generated, such as buying back more of our outstanding debt, reinvesting in our real estate asset management business or purchasing shares under an expanded share buyback plan,” he added.

Rising Interest Rates Pose Significant Risk

For MuniMae and many other owners of fixed-income assets, rising interest rates are a significant business risk.

MuniMae owns and manage tax-exempt bonds, a substantial majority of which are backed by affordable multifamily rental properties. It also manages tax credit equity funds for third party investors which invest in similar affordable multifamily rental properties.

MuniMae borrows money on a short-term floating rate basis to finance its bonds, which are primarily long term and fixed rate. This differential or spread is how it earns its money.

A future rise in short-term rates would increase its borrowing rate, while its income would remain unchanged.

For 2011 and 2012, MuniMae generated about $11.5 million in net operating cash.

“A 200 basis point increase in floating rates would have caused our debt expense to increase by $11.2 million, therefore eliminating virtually all of our positive net operating cash flows,” Falcone said.

In addition, because its bonds are fixed rate, a rise in long-term rates would decrease the value of its bonds, and thus cause its common equity to decline, while also increasing the risk in collateral costs, which would restrict its liquidity.

“A similar rise in long-term rates could have caused our net worth of $95 million at March 31, 2013, to decline substantially and possibly entirely,” he said.

Falcone has said in the past that the company did not have the financial means to hedge the risks posed by rising interest rates.

Interest rates for 30-year fixed-rate mortgages have risen about 0.5 percentage points in the past several weeks. The 30-year fixed mortgage rate on Zillow Mortgage Marketplace was 4.41% as of this writing, up 24 basis points from 4.17 percent at this time a week ago.

The last time rates exceeded 4.4% was July 26, 2011.

The recent upturn in interest rates has sparked fears among some investors that the economic and housing recoveries would be choked off in the early stages before they are able to produce sustained growth.

But Frank Nothaft, Freddie Mac's chief economist, believes current strong demand is strong enough to withstand rising interest rates, at least for a while.

“While rising interest rates will reduce housing demand, rates would have to increase considerably more before the reduction in demand for home purchases would be substantial," noted Nothaft. "Nothing in the recent trends suggests that we need to fear a major slowdown. A gradual rise in interest rates will not derail the recovery, and are an indication that the overall economic situation is improving."

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