In times of fluctuating interest rates, commercial mortgage brokers often maintain a delicate balance between keeping lenders at the table and convincing borrowers that it is better to close a higher-cost loan than to delay a project.
When comparing the cost of a substantial rate increase with all the expenses associated with postponing a construction project in the hope that rates will fall, starting the project is usually the right answer. The current lending environment may be the perfect time for mortgage brokers to educate their clients on the benefits of a spread-based loan with payments that fluctuate as base interest rates move up or down.
“It is better to realize a profit today than to face the uncertain costs of a delayed development in the future.”
Borrowers can often buy a collar, an option used to hedge exposure to interest rate movements, to help protect against large rate increases. But the reality is that short-term construction or bridge loans that experience rate changes aren’t likely to be very significant to the overall cost of a project. For instance, any construction loan amount with a 3% higher rate makes a relatively small difference on a monthly basis as funds are disbursed and the project nears completion.
Not worth waiting
A $50 million multifamily housing project, for example, would experience a relatively small increase in its overall cost if rates rise when compared to the potential internal rate of return realized by most real estate projects of the same size. After all, how long can apartment developers wait without putting their money to work while rates remain in fluctuation? Not moving forward means losing money. The developer needs an income-producing asset.
Using this multifamily development as an example, let’s say the cost of capital has increased by 400 basis points from the previous year when the financing has been approved. Due to the higher rate, the actual cost of the project would increase by about $2 million. Dividing this figure by the 150 units in the building comes to $13,333 per unit.
If the average unit was originally priced at $350,000, then the additional cost of $13,333 results in an increase of less than 4% per unit. This will almost certainly be much less than the average market increase in price during the next 18 months.
At the same time, the cost of carrying the undeveloped land and not building the project will also be much more than 4%. This argument gives the mortgage broker a logical reason to have an educated conversation with the client about focusing on the income opportunity and moving forward to build the multifamily asset.
Taking action
A broker needs facts in this period of fluctuating rates to be able to close more loans. While the cost of a few points of additional interest may well be significant, the reality is that the carrying costs — the total expenses associated with owning a property — may be considerably more than the increased cost of financing.
This is especially true when comparing the profits gained once a project is completed versus doing nothing. Delaying a project always results in nothing gained, either in cash flow from tenants or in a sales transaction. An argument can be made in waiting for the market to recover, but the facts rarely support this theory.
According to 2021 data from the National Council of Real Estate Investment Fiduciaries, the average annual return on investment (ROI) for U.S. commercial real estate over the prior 25 years was 10.3%. This compares favorably to the S&P 500, which had an average annual ROI of 9.6% during the same period. Given the current market parameters, it seems to make obvious sense to borrow capital and maximize returns rather than sitting on nonproductive assets.
Sitting still will always result in nothing. Conversely, moving forward despite a real or perceived interest rate risk is likely to produce a viable return if all other costs are equally well managed.
Market factors
The potential profit for a particular real estate investment can be affected by various external factors. Clearly, the key elements include the market conditions at any given time. When there’s limited inventory available, it typically drives up the price of properties that are being listed for sale. This type of seller’s market will impact ROI in a positive direction.
The upfront cost to acquire real estate also factors into the profit that investors stand to earn when they’re ready to sell, and the cost of debt is part of this calculation. The more you pay for a property, the less money you stand to pocket in the end, unless the value has appreciated significantly (which has happened in many markets in recent years).
The prevailing cost of debt, which can also impact profits when developing or marketing real estate, is of interest to people in the capital markets. When interest rates are relatively high or on an upward trend, as they are today, prices often decline to attract wary buyers. A lower sales price means a lower profit for the current owner. But as previously mentioned, it is far better to develop now and borrow at a higher rate than to do nothing, which also has a cost.
Location is another key factor that will always increase or decrease the ROI. A residential property located alongside a highway, for instance, is likely to command a lower sales price than one near a park or a beach. Amenities included in the development project aid in marketing and absorption efforts, and they are factors of relevance for lenders when projecting support for the loan in question.
The cost of materials required for construction or renovation is an additional factor that impacts ROI. When goods such as lumber or steel are more expensive, it drives up the amount spent on a project, which eventually cuts into profits earned when the property is sold.
This is a perfect corollary to the increased cost of debt. Yet many borrowers are more concerned about interest rate increases, which even in times of fluctuation are often substantially lower than any changes in raw material costs. This is a good discussion point for a commercial mortgage broker when talking with a potential client. It is better to realize a profit today than to face the uncertain costs of a delayed development in the future.
Historical basis
For comparison’s sake, it may be helpful to look back to when average interest rates for residential mortgages dropped to a record low of 2.65% in January 2021. To put it into perspective, the monthly payment for a $100,000 loan at the historical peak rate of 18.63% in October 1981 was about $1,559, compared to about $403 at the rate of 2.65% nearly 40 years later.
The markets then experienced the recent roller coaster, with rates going from the lowest point on record to the highest level since March 2002 in a period of about 21 months. After the COVID-19 pandemic hit the U.S. in 2020, the Federal Reserve cut its overnight rate to nearly zero to stabilize the economy, as businesses closed to stop the spread of the virus and public health officials ordered Americans to shelter in place.
Rates spent much of 2021 between 2.7% and 3.1%, giving many borrowers an opportunity to refinance or buy real estate at some of the lowest rates ever recorded. Then, in June 2022, the increase in the Consumer Price Index (an important gauge of inflation for consumer goods and services) peaked at 9.1% — the largest 12-month spike in decades.
Even before the inflation report, interest rates were already headed higher, starting the year off at 3.55%. They steadily rose each month in 2022, with the weekly average 30-year fixed rate rising to 7.08% as of this past October. By June 8, 2023, the average 30-year mortgage rate stood at 6.71%, according to Freddie Mac.
Yes, this can be scary when you look at the rapid changes and volatility. For prospective borrowers, however, these types of rate increases may well result in a relatively small increase in their overall project budget, one that’s not dissimilar to an increase in the cost of construction materials.
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One truth about commercial real estate is that good deals with solid foundations will still get done in times of financial instability and rate fluctuations. One of the main tasks for mortgage brokers is to help their clients look past difficulties and find a path to funding their project. The other option is to do nothing, which is sure to result in nothing gained. ●
