Real estate developers and property owners currently face the first rising interest rate environment in nearly a decade. They’ll need to determine their best course of action, and make their move soon. Deciding what to refinance, what projects to exit, what loans to prepay or whether to make any changes at all requires careful planning.
The Federal Reserve has indicated it will begin raising short-term rates, possibly at one of the remaining Federal Open Market Committee meetings this year. The target range for the federal funds rate is currently zero to 0.25% and the Fed hasn’t raised rates since June 2006, which seems like a lifetime ago. (For a little perspective, back then Facebook was only available to college students.)
How to Respond
A rising-rate environment is a time of great uncertainty. More costly loans can impact a project’s returns, whether it’s an operating property or one in the development stage. For example, a developer opens with a three-year construction loan, after which it may go to secure permanent financing for ongoing operations. In a rising interest rate environment, the developer could find him/herself in a precarious position in three years.
For development projects, a developer may want to bring in an equity partner or partners in order to lock in some profits for the developer and reduce risk. For operating properties, owners can try to recapitalize current project deals, swapping out current loans or looking for new sources of financing. If necessary, this may mean buying out current partners who want to cash out and bringing in new partners for fresh capital.
Developers/owners can also evaluate the use of interest rate swaps, swaptions and caps. For example, they can negotiate a swap agreement, which allows them to swap out a variable-rate loan for a fixed-rate loan. By doing this the developer/owner can lock in a fixed rate, eliminating the risk of being exposed to rising rates. They can also enter a swaption, which gives the developer the option but not the obligation to enter into an underlying swap. They can also make use of cap agreements, which caps how high a variable interest rate can move upward. This provides stability for a long-term project: if you cap the loan’s rate, the developer knows it will have an acceptable interest rate and can budget accordingly.
“Deciding what to refinance, what projects to exit, what loans to prepay or whether to make any changes at all requires careful planning”
These actions all have downsides, typically in the form of fees. Most mortgages and commercial property loans are securitized. Because investors purchase these securities for their guaranteed rates of return, a borrower who pays off a mortgage early, or renegotiates the interest rate, can disrupt the investment.
Thus developers/owners sometimes face steep prepayment penalties to get out of current loan agreements. They might also have to pay defeasance fees – the cost for a borrower to replace the original collateral with substitute collateral that pays the same rate of return.
Developers and owners need to decide whether paying a substantial prepayment or defeasance fee is worth it. Will they be compensated by savings they achieve by getting out of a variable-rate loan before rates rise, or locking in a low rate of interest on a loan that is nearing maturity? Running the numbers for each scenario can play a key role in determining which option leaves the most money on the table.
Making the Decision
Whether it’s renegotiating or prepaying loans, all parties in a real estate project need to be on the same page. And here’s where conflict often arises, when partners have different interests and aims. For example, an overseas investor may want to wait, while a domestic one may want to refinance or cash out of the deal. It’s important to leverage outside advisors to serve as a “referee” in such situations, and try to find common ground.
Other considerations when evaluating whether to prepay a current mortgage include partner goals and lockout periods preventing any prepayments. For instance, a developer/owner might pull refinance proceeds out of a deal (incurring penalties) and then park the cash in a savings account that yields little interest. Or they could pay a huge defeasance penalty for a loan with less than a year left in its maturity. In either case, determining the wiser course requires careful analysis of the numbers.
A rising-rate environment is an unfamiliar world for property developers/owners who have grown used to nearly a decade of very low interest rates. They’ll need to move quickly but also wisely. It’s important to map out a well-considered strategy to cope with uncertain times ahead.
For more information, please contact John Schmuck.