A 900% Jump in Hedging Costs Looms Over Commercial Mortgages
May 20, 2022 | John Gittelsohn | Bloomberg
A fee on US commercial mortgages has surged so high that borrowers can’t ignore it and may not be able to afford it.
Adjustable-rate loans on commercial real estate — including about $350 billion of commercial mortgage-backed securities — almost always require interest-rate caps, a kind of insurance to protect monthly debt payments from soaring out of control when the Federal Reserve boosts rates.
Now that the Fed really is hiking, the cost of that protection has multiplied by 10 this year. For a $25 million mortgage, the cost was $535,000 in early May, compared with just $52,000 in January, for a two-year 2% rate cap, according to Chatham Financial Corp., a hedging advisory firm. Prices for the a similar three-year 2% cap rocketed up as much as 4,000%.
“Last year, it would be like buying flood insurance for your house in the mountains,” Chris Moore, a managing director at Chatham, said in a telephone interview. “This year, it’s sort of like buying flood insurance for your house on the beach as a hurricane is making landfall.”
The costs are high enough that it may prevent some investors in offices, hotels, malls or apartment buildings from paying for property improvements or potentially even closing a deal. Rate caps are initially paid along with other closing costs, such as commissions and transfer taxes, soaking up about 2% of the principal at today’s prices, said Dylan Kane, a managing director in the New York capital markets group of Colliers International.
A borrower with a two-year $25 million loan on an apartment building may have $500,000 less, for example, to buy new windows, flooring or other improvements.
“If you want to close a transaction today, that’s just the cost of doing business,” Kane said. “Nothing in the last three months has shot up quite like this. It’s kind of crazy.’’
The biggest sticker shock may come for borrowers who need to refinance or extend maturities on existing debt. Almost $125 billion of CMBS with with adjustable-rate loans are maturing by the end of 2023, according to data compiled by Bloomberg. More is in the pipeline: About 70% of CMBS and collateralized loan obligations originated this year and last are floating-rate debt, double the share before 2021, according to the Commercial Real Estate Finance Council.
“If a mortgage was taken out two years ago, when rates were very low, the cost of the rate cap was nothing,” Lea Overby, a real estate credit analyst at Barclays Plc, said in an interview. “Now, it can change a borrower’s decision at an inopportune time.”
The Fed has hiked rates by 0.75 percentage point since March as it tries to tamp down inflation, which already boosted expenses for property owners, such as lumber and labor. The central bank has made it clear it will keep tightening, meaning more pain from rising rates is coming. The implied rate for Fed Funds Futures is almost 3% by February 2023, up from less than 1% today.
So far, higher borrowing costs haven’t hit property values, but that’s likely to change. Green Street, a research analytics firm, wrote in a May 11 forecast that commercial-property prices may decline as much as 10% by the end of this year, because “surging interest rates have dramatically altered the landscape.”
Floating-rate loans usually charge some benchmark interest, like the Secured Overnight Financing Rate, plus extra interest on top of that. The insurance pays out when SOFR crosses a specified threshold under the cap agreements. Those kinds of loans have been popular with fixed-income fund managers who want holdings in their portfolios that keep up with inflation.
Even deals with top credit ratings require protection. Blackstone Inc.’s $1.76 billion mortgage on a warehouse portfolio includes a two-year interest-rate cap agreement that kicks in when SOFR hits 3.5%. The agreement would have cost about $12 million when the debt was put together in March, up from about $1.8 million in January, according to Chatham Financial’s Moore. Blackstone declined to comment.
Most of the protection plans are sold by banks like Goldman Sachs Group Inc., which provided Blackstone’s coverage. Other prominent sellers include Sumitomo Mitsubishi Banking Corp., Wells Fargo & Co. and U.S. Bank NA, Moore said.
While rising interest rates have pushed some cautious borrowers to lock in long-term funding at fixed rates, that’s not an option for many investors with shorter horizons. Loans for construction, building improvements and post-construction financing are typically interest-only floating-rate debt. And some borrowers also bet that what goes up will come down.
“If you think a recession is coming, then rates will eventually fall,’’ Lisa Pendergast, executive director of the Commercial Real Estate Finance Council, said. “You may need to contend with higher rates for a period but then may take advantage of lower rates should the economy falter.’’
Source: Bloomberg
