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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   February 2010

Fixed Rates: Friend or Foe?

Although fixed interest rates may seem safer than variable rates, other risks may arise in some cases

Fixed Rates: Friend or Foe?

With commercial mortgage-backed securities transactions picking back up in recent months, historically low long-term Treasury rates and declining spreads for commercial real estate loans, the opportunity for long-term, fixed interest rates is slowly returning for commercial mortgage borrowers. Most real estate and mortgage professionals may see this as an opportunity to reduce interest-rate risk.

But this might not always be the case. In some instances, fixed rates actually might increase other sources of risk, including operational and financial risk.

Here's what you should know about fixed and variable interest rates and their related risk to best help your clients.

•  •  •

For mortgage brokers, helping clients understand the risks involved in real estate and how to best mitigate them is critical to earning referrals and repeat borrowers.

Fixed-rate loans often are considered a way to mitigate or decrease risk in a mortgage transaction because they control a primary source of uncertainty: interest-rate changes.

But risk often is like a balloon that expands on one side when pushed on the other. As such, mitigating interest risk requires examining all sources of risk and offsetting factors comprehensively.

Because of its often-leveraged financial structure, real estate contains two primary types of risk: operational risk and financial risk.

Operational risk comes from multiple sources, including:

  • Supply-side market risk, which is based on what developers, lenders and investors might do to create new supply;
  • Demand-side market risk, which is based on the behavior of users of commercial real estate; and
  • Purely operational risks that can come from unexpected changes in revenues or expenses.
  • Financial risk also comes from numerous sources, including:
  • The length of the interest-rate-reset period, compared to the length of the lease;
  • The loan size at maturity, compared to the likely value after depreciation; and
  • The coverage provided by cash flow compared to debt service.

Varying levels of risk

The level of operational risk often depends on the property type or the market. For instance, a commercial property that has credit-quality tenants, arrangements to pass expenses to tenants and strong barriers to entry often has limited operational risk because the cash flow available for debt service is relatively stable and predictable.

These properties typically can handle maximum financing risk that uses the highest leverage possible, combined with a fixed interest rate at a low coverage ratio. This kind of arrangement may turn the property's cash flows into an annuity with predictable returns and probability of repayment.

Other property types or markets have high operational risks, however. For example, apartment communities or self-storage facilities typically have relatively short lease periods. Also, some retail developments depend highly on a percentage of sales revenue. Barriers to entry might be low for these property types because of zoning or construction costs. The properties are therefore subject to supply-side market risk. Plus, property-owners may incur expense changes with limited opportunity to pass increases on to tenants -- particularly when the owner is responsible for all utilities.

A property with one or more of these characteristics already has high operational risk and doesn't need to increase its risk profile further by adding high levels of financial risk. Using a fixed rate on these transactions may decrease interest-rate risk, but the risk simply changes form and becomes cash-flow risk instead.

Playing the leverage game

Few properties can be competitively acquired or developed without using leverage. So how can a property use financial leverage without compounding its financial risk? One way is to look at the length of the interest-rate period and try to match it to likely changes in the cash flow available for debt service. Fixed rates might not always be the answer here.

For example, for commercial tenants with rent-escalation clauses tied to inflation, revenue will more likely correlate with short-term variable rates than with long-term fixed rates. In such a situation, if you picked the long-term fixed rate and ended up in a deflationary rate environment, the fixed rate has increased risk, rather than mitigated it.

Viewed another way, choosing a fixed interest rate is similar to having a property with an extra-high dose of fixed expenses. For example, for a property with variable-rate debt, fixed expenses such as taxes and insurance may comprise only 10 percent of revenue. On the other hand, with a fixed-rate loan, fixed expenses will include taxes, insurance and the interest rate and likely will comprise as much as 50 percent of revenue.

A variable-rate loan has a more fluid expense structure with the potential to adjust to inflation or deflation. But a fixed-rate loan has locked in a significant share of its expenses and therefore needs a more stable cash-flow pattern.

Several scenarios might cause a property's cash flow available for debt service to fluctuate in ways that might correlate with short-term interest rates. These may include:

  • Lease periods that are shorter than the interest-rate-reset period;
  • Leases or expenses with inflationary adjustments;
  • Market demand that is highly cyclical (e.g., fluctuating user demand based on discretionary spending);
  • Leases with percent-of-sales clauses;
  • Expenses that depend highly on occupancy or other cyclical factors; and
  • Structures that pass through a high percentage of expenses to tenants.

Mitigating risk: 5 tips

Here are five tips to help your clients understand interest-rate risk and how to mitigate it:

  1. Don't assume that fixed interest rates create a safer cash-flow stream than variable rates. This isn't always the case. Make sure your analysis includes a close look at both options.
  2. Consider how the property's available cash flow for servicing the debt could change with factors that also might affect short-term interest rates. This can include revenue or expense patterns that are subject to inflation, deflation and business cycles. Run a sensitivity analysis for your client that includes multiple scenarios.
  3. Consider the borrower's or lender's overall portfolio, if possible, and whether it is financed with fixed or variable interest rates. Clients with diversified portfolios generally will be well-served by having a combination of fixed- and variable-rate debt applied to the appropriate properties (e.g., variable-rate debt for properties with highly variable cash flows).
  4. Consider using interest-rate caps for borrowers or floors for lenders, either from third parties or built into the loan agreement, with strike rates set at or near break-even levels. Even if a property's characteristics suggest a variable rate is more appropriate, clients sometimes can't get over the potential interest-rate uncertainty. Caps on interest rates may help alleviate these clients' concerns.
  5. Consider historical interest-rate data for fixed- and variable-rate loans, preferably over a full business cycle. Calculate whether a borrower would have benefited from having had a fixed rate or a variable rate in the same financing period. This is particularly beneficial when looking at loans that started 10, 15 or 20 years ago.

Mortgage brokers and their clients should be cautious about assuming fixed-rate debt is automatically safer or less risky than variable rates. In some instances, it's not the case.

The key to successful decisionmaking is to understand how the cash-flow stream may change in a variety of interest-rate scenarios, to evaluate all sources of risk and to look at the capital structure comprehensively.


 


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