Making the calculation on whether to lock in lower interest rates today
There is a tremendous amount of multi-housing debt maturing in 2014, 2015 and 2016–$200 billion in 2015 alone–an imposing tsunami of maturities. In today’s capital market, multi-housing investors with maturing debt are facing a quandary. On the one hand, refinancing is an option because interest rates are still at or near historically low levels. On the other hand, it’s hard to stomach paying a stiff pre-pay penalty in order to take advantage of today’s low rates. Should an investor shoulder that pre-pay penalty now and refinance, or does it make sense to wait a year or two? Although there is ample multi-housing capital available in today’s market—an estimated $300 billion in 2014—there is also tremendous uncertainty about interest rates moving forward. Easing of monetary policy by the Federal Reserve and a rising 10-year U.S. Treasury that is projected to end 2014 around 3.50 percent could be signaling the “end of the tunnel” for historically low interest rates. While capital is prevalent, will the money still be available when the wave of maturities crest or will investors have to scramble? Investors hear about rising interest rates everywhere they go – is there a way to lock in a low rate today?
When the Low Rate Music Stops
We all remember playing musical chairs as a child. The game is a good analogy for what is happening in the current multi-housing capital market. The low-rate “music” is blaring and investors with maturing debt are anxiously circling the “chairs” that represent current low rates. The question is, when the music stops, will there be enough chairs? For a borrower who has a loan coming due in 2015, a forward rate-lock can be an attractive way to take the risk out of the rising interest-rate environment, as well as any jarring economic or geopolitical events that could change the capital landscape. A forward rate lock simply means committing financing on a property now with a rate that is locked in until the loan funds in 2015. It’s like having a guaranteed chair in the game of interest rate musical chairs. Not only that, but a 12-month forward rate lock will help burn off a potentially costly pre-pay penalty.
Pros and cons of forward rate lock
Naturally, the key question on the mind of many investors who are reading this article is: Does the cost to lock in an interest rate now outweigh the anticipated higher interest rates 12 to 18 months from now? We believe there is more risk and uncertainty in waiting until the existing note comes due. Here’s why:
- The current interest rate on 10-year Treasuries is around 2.75 percent. To forward rate lock a loan, it typically costs the borrower a premium of three to five basis points per month, after a grace period of 60 to 90 days.
- If we assume a four basis-points-per-month cost for a forward rate lock and funding at the end of 2014, with economists targeting a 3.50 percent 10 year Treasury compared to today’s 2.75 percent, then there would be a favorable delta of about 50 basis points between potential rates—assuming the other components that make up a note rate stays static.
But wait! Two more key factors need to be considered to make the forward rate lock determination:
- As interest rates rise, historically there have also been increases in capitalization (cap) rates. Another dilemma for the investor is whether or not to work with today’s cap rates versus cap rates a year from now. The investor needs to consider current equity in the property and the current loan-to-value (LTV), compared to what the LTV could potentially be in a rising rate environment where cap rates could be on the rise as well. Will rents rise at a rate that is needed to support rising cap rates?
- Borrowers also need to consider geopolitical forces in the economy. For example, the current political crisis involving Ukraine and Russia, which is happening in close proximity to major oil producing nations in the Middle East, could send jitters through global oil markets. Any crisis involving foreign oil-producing nations could have a major economic impact that could affect interest rates.
A step-by-step solution
Step one: Calculate the pre-payment penalty T
he capital advisor will provide the investor with a breakdown of what financing looks like with today’s interest rates, along with an estimate of what a forward rate-lock might look like for six months and 12 months. Additionally, the capital advisor can calculate the estimated pre-payment penalty today, and what it would be six and 12 months later. This cost analysis will provide options that enable the borrower to make an educated decision. Some investors may feel that interest rates will continue to remain low and decide to sit on the sidelines, waiting until the loan comes due or open for pre-payment. But investors need to be aware of this financing dynamic: the larger the pre-payment penalty, the greater the long-term benefit of placing permanent financing. This is due to the fact that the pre-payment penalty is typically more costly because of a current high rate loan and is the delta between today’s lower rates. In these situations, there is typically significant monthly savings. Also, as interest rates rise, pre-payment penalties typically decrease.
Step two: Determine the property plan
This usually involves answering a few key questions:
- How long is the investor planning to hold the property?
- Is the investor planning on any property improvements or value enhancements?
- If the investor is planning to sell the property within the term of the potential loan, will the loan be assumable and attractive to a buyer?
Step three: Do a cost/benefit analysis
This step requires the answer to one critical question: How long will it take, at the new interest rate, to recoup the cost of refinancing? The capital advisor will do the calculation that shows monthly and yearly savings resulting from refinancing at the lower rate.
There is one more long-term benefit of refinancing with a forward rate lock. In many cases, the financing is assumable and transferable to a new buyer without prepayment penalty. When the time comes to sell the multi-family asset, favorable in-place financing can enhance the value of the property. Even if the investor refinancing is a short-term holder, refinancing at historically low rates can deliver greater returns and greater value to a buyer. For this reason, and for all of the other benefits outlined in this article, it behooves any multi-family borrower in today’s changing market to find a capital adviser that offers a wide range of financing options with a forward rate-lock component.