A slow recovery in the U.S. economy has prompted more and more borrowers to bet that interest rates won't be rising anytime soon. And still others, fueled by fears of overall uncertainty, are satisfying their appetites with flexible financing.
Whether it's floating-rate deals or adjustable fixed-rate loans, or some other hybrid structure, many borrowers don't want to be locked into long-term financing. For the moment, it appears that luck is on their side. The Federal Reserve in September hinted at yet another rate cut to offset economic weakness marked by stagnant job growth.
Floating-rate deals account for one-third to one-half of all commercial real estate borrowing in the current lending climate due to the desire for flexible, transitional funding, says Manus Clancy, managing director at Trepp LLC, a New York-based provider of commercial mortgage-backed securities (CMBS) analytics.
Gone are the days of the buy-and-hold commercial borrower. “Endemic to the owners is the idea that at the right price, they'll sell it [their property],” notes Dan Reynolds, managing director of capital markets at Chicago-based Jones Lang LaSalle. Many borrowers would like to be long-term holders, but in this uncertain market floating-rate terms fit their needs.
Most floating-rate deals are pegged to the London Interbank Offered Rate (LIBOR), the interest rate that the largest international banks charge each other for loans. LIBOR, which moves in lockstep with government lending rates, including the U.S. Federal Reserve's key interbank rate, has dropped 50% from last year (please see table on page 26), to about 1.82% as of mid-September.
That precipitous dip in LIBOR has made floating-rate loans, typically two to five years in length, far more attractive, says John Scheurer, managing director of commercial real estate at Allied Capital, a Washington, D.C.-based business development company.
Floating-rate deals are so inexpensive that in many cases it's preferable to fixed rate, which is highly attractive in its own right. Fixed-rate financing has been making headlines as the 10-year Treasury yield, the benchmark for most commercial lending, slipped to 3.65% in late September, the lowest yield in 40 years.
Indeed, the 2- to 30-year yield curve steepened by more than 100 basis points over this time last year, bringing fixed-rate yields down to unheard of borrowing levels, says Todd Everett, managing director at Des Moines, Iowa-based Principal Capital Real Estate Investors.
Ironically, despite a year of record-low interest rates, commercial loan originations through the first six months of 2002 were flat — growing at 0.6% over the first half of 2001 to $32.8 billion — according to the Mortgage Bankers Association (MBA). The results were based on a survey of the 45 leading mortgage bankers.
Deteriorating real estate fundamentals across several property types, particularly in the office sector, coupled with a lack of a federal backstop for terrorism insurance have put a halt on deal making. (For more on the survey's findings, please see the September issue of NREI).
High vacancy rates continue to put a damper on commercial borrowing, agrees Samuel Miller, co-chairman and treasurer of Cleveland, Ohio-based Forest City Enterprises. Yet he expects those borrowers who are in the market, particularly with well-stabilized buildings and low vacancies, to stick overwhelmingly with floating-rate borrowing.
Those that want some kind of fixed-rate financing, but do not want the limitations, are even opting for a floating rate while still creatively achieving some fixed-rate borrowing. Reynolds of Jones Lang LaSalle cites a deal involving a pension fund client. The floating-rate loan through a consortium of commercial banks was expected to close in September.
“Initially we were going to have some combination of floating and fixed,” Reynolds recalls. But given that variable-rate borrowing is so competitive, the client opted for floating-rate funding, a portion of which could be swapped into fixed-rate funding at some point.
Risks and Rewards
What makes floating-rate loans attractive in this uncertain market is the ability to exit financing quickly. Fixed-rate loans have punitive prepayment penalties — about 1% to 2% of the loan amount — making it impractical for owners to opt out early to refinance. Jonathan Kieswetter, president of Grace Capital Group, a real estate mortgage broker based in Irvine, Calif., says that in rare instances borrowers are throwing caution to the wind and taking the prepayment penalties.
“We're doing one refinancing where the borrower will take a $100,000 prepayment penalty to reduce the interest rate by almost 2.5%. The borrower can make up the loss in less than 12 months, so it will have increased cash flow,” says Kieswetter.
But borrowers who favor floating-rate deals need to exercise caution, experts say. “Borrowers are rolling the dice and saying they can enjoy a 150 to 175 basis point benefit on a $5 million loan,” according to Peter Grabell, senior vice president and head relationship manager at Bridger Commercial Funding in Chicago.
The benefit comes from savings achieved via lower debt service. “But what they're doing is gambling. Once the shape of the yield curve changes, there is no guarantee that today's 6% to 6.5% permanent mortgage loan will be around anymore,” Grabell adds. Ultimately, he predicts, LIBOR will go up and the yield curve will flatten, and borrowers who didn't lock in low rates will pay the price.
Indeed, borrowers' penchant for floating-rate loans has some mortgage bankers questioning the logic. “My initial impression is that fixed-rate loans are so low now, you wonder why you don't just see more of them. You're getting more people looking for low variable rates,” says Scott Wolfe, principal of Wolfe Financial, a mortgage banker based in Denver, Colo.
A typical floating-rate loan lately comes with a lot of leg room. It attracts the larger borrowers, those repositioning properties or those looking to increase income on the property before locking in long term. Floating-rate deals typically charge borrowers approximately a 4.3% interest rate for two to five years, or LIBOR plus a spread of 250 basis points, compared with a traditional fixed-rate loan that carries a 6.5% interest rate for seven to 10 years. A three-year floating rate loan typically features an option to extend the terms a year or two.
Grace Capital's Kieswetter says California borrowers, in particular, prefer the flexibility of floating-rate mortgages over their fixed-rate counterpart. He's observed a definite increase in floating-rate loans there this year. “California is more creative, more demanding when it comes to loans,” Kieswetter believes. “The adjustable rate appeals to borrowers who want the flexibility in and out of the loans fast.”
Other ways borrowers look for quick exits include taking on a 15-year loan fixed for three, five, seven or 10 years that then converts to variable rate for the remainder of the term. Kieswetter says adjustable Fannie Mae multifamily loans are gaining in interest as well. Fannie Mae can often offer a lower fixed rate, but it also has a sliding cap or ceiling rate, a maximum interest rate borrowers have to pay on their loans that ranges between 2% and 3% over the original interest rate.
Savings & Loans also have heeded requests for ceilings lately. “The borrower has been saying, ‘If you get a floor, then in order to protect myself I want a ceiling,’” says an official at an S&L in Chicago who asked not to be identified. Other S&Ls offer greater flexibility with five- to seven-year fixed-rate loans that roll into an adjustable rate for eight or 10 years.
With ceilings or caps, borrowers are leaving themselves an escape route if rates begin to rise. “Our clients are getting a keen interest in these (ceilings), somewhere in the 8% to 9% range,” says Grace Capital's Kieswetter.
Lenders, too, are concerned about how LIBOR can ramp back up and whether borrowers have the means to repay loans. “I think institutions are increasingly looking at the utilization of interest rate caps [to protect the borrower's exposure]. However, the competitive marketplace has limited the ability of lenders to receive this structural protection,” says Everett of Principal Capital.
A number of banks provide caps on a yearly adjustment basis and for the life of the loan, such as 2% per year with a lifetime cap of 5% or 6%. With the uncertainty of the economy and when the next Federal Reserve move in interest rates will occur, ceilings have provided some protection. “Borrowers say, ‘I remember the day when we had 18% interest rates.’ When getting into the variable interest rate market, they like upside protection,” says Wolfe of Wolfe Financial.
Banks also use floors, the minimum interest rate set on loans, but not all are able to persuade borrowers to agree to the terms. Floors are a disadvantage for borrowers because they can result in higher borrowing costs.
Keith Belcher, managing director at JER Partners, a real estate investment and asset management firm based in McLean, Va., says that as a result some banks are struggling with the implementation of floors. “Lenders are competing against each other and having a harder time getting floor rates. Many are behind in loan production and are agreeing to lower floor levels or no floors at all,” he says.
When Will the Pendulum Swing?
With banks having difficulty setting floors and borrowers finding it a challenge to secure interest rate caps, some industry experts think the tide is turning. Renewed interest in obtaining fixed-rate borrowing is likely in the next few months, they believe.
“As rates start to tick back up, you will see borrowers trying to convert from floating to fixed,” says Belcher. But, “there will continue to be floating-rate demand for those who plan to own for a short time or refinance over 12 to 24 months.”
Patrick Corcoran, head of CMBS research at J.P. Morgan, also expects a shift in borrower sentiment. “Much of this is dependent upon economic recovery, but if this happens you will see a flattening of the yield curve and the advantage in floating rate shift to fixed rate,” he concurs.
Even lenders of floating-rate loans say they may target some fixed-rate business in the fourth quarter. Chris Lehnes, vice president of business development at CIT Small Business Lending Corp., based in Livingston, N.J., says “small businesses prefer to have benefits that are flexible.” But, “when the curve goes back to a traditional form, we may offer some fixed rate, but it's not our core target.”
However, the No. 1 Small Business Association (SBA) lender, which recently topped $2 billion in total lending and $1 billion in construction lending, also has protection strategies in place.
“To protect ourselves and our customers, we have built in a stress test where we analyze customer credit at a higher rate. If the prime rate is at 4.75%, we build in 1.25% into that [to achieve] 6%,” says Lehnes.
Investors Cash in on CMBS
In the securitization markets, floating-rate issuance is still in vogue. Four floating-rate CMBS issues totaling more than $2.7 billion are due in the market by November from issuers including Credit Suisse First Boston, Salomon Smith Barney and JP Morgan Chase.
Four floating-rate CMBS deals started the recent trend last July and August when over $3 billion in deals surfaced and then another $2.7 billion arrived in September. Floating-rate CMBS issuance for the first half registered $7.8 billion, up 50% over the same period last year, according to Salomon Smith Barney.
Several of the deals feature debt provided via secondary mezzanine loans, or interim financing. The growing investor demand for floating-rate CMBS, which has commonly included mezzanine financing, demonstrates that private real estate investors have confidence in underlying commercial mortgage fundamentals.
“The use of a mezzanine loan on each floating-rate loan within a pool has increased recently,” confirms Darrell Wheeler, director of CMBS research at Salomon Smith Barney. He expects about $12 billion in floating-rate CMBS this year, up from $11 billion last year.
“With rates on first mortgages at such low rates, layering in mezzanine financing allows the overall capital structure to be blended at attractive levels,” adds Donald Braun, president of Hall Financial Group, a provider of mezzanine financing based in Frisco, Texas.
Experts predict overall domestic CMBS issuance will total about $60 billion this year, down from last year's near-record of $70 billion.
Floating-rate CMBS is becoming widely accepted. Before the CMBS market gained a foothold in the 1990s, regional banks were the only real source for floating-rate loans. “But since 1997, borrowers have been able to use the floating-rate CMBS market and obtain terms similar to the bank's terms,” adds Wheeler.
The fixed-rate CMBS offerings also have maintained their following, even with yields falling to 6%. As Salomon's Wheeler explains, even with some relative value investors jumping ship from CMBS to higher yielding corporate bonds, many of the tried and true CMBS investors are still flocking to the product.
More so than yields, CMBS spread performance has had a lot to do with that decision. The more stable and narrowing CMBS spreads, compared with the wider, credit-conscious corporate spreads have been attractive.
For example, over a three-year period, the average spread difference between single-A rated corporate bonds was 28 basis points, but this year that difference narrowed to two basis points, Wheeler explains.
The value in CMBS might best be described by JP Morgan's Corcoran: “The whole time that stocks were viewed so wonderfully, real estate was the bad boy. Now that's turned around.”
Kathleen Fitzpatrick is a New York-based writer.