COMMERCIAL MORTGAGES: Coming 'storm' may affect cash flow, property values

Real Estate Research Corp. aptly titled its first-quarter research report "Bracing for the Storm."

Chicago-based RERC, a frequent contributor at the annual VCU Real Estate Trends Conference, says the "storm" is rising interest rates. It warned real estate owners to brace for the effect higher rates will have on cash flows and values.

RERC predicts that, with the economic recovery strenghtening and significant job growth under way, "it is likely that the federal-funds rate will be increased sooner rather than later and interest rates will start inching upward, which in turn will put property values at risk."

To be sure, most economists have trouble envisioning anything but an increase in federal-funds rates in coming months. (The federal-funds rate is a rate charged to banks needing overnight loans to meet reserve requirements.) This rate increase will affect other short-term or floating rates. The effect on long-term rates and property values, however, is open to debate.

Long-term commercial mortgage rates are largely affected by the yield on 5- and 10-year U.S. Treasuries, which move more swiftly and are more volatile than the shorter-term, federal-funds rate.

In fact, these yields started moving upward significantly at the first sign of job growth several months ago, increasing more than 100 basis points, or 1 percentage point, since the third week of March.

During the same period, the Federal Reserve took no action on the federal-funds rate. A strong argument could be made that rates have already gone up. Even though the Federal Reserve is likely to raise rates at its next meeting (scheduled to begin tomorrow), that action likely will have little significant effect on long-term rates.

According to the Barron's/John B. Levy & Co. National Mortgage Survey, commercial mortgage rates are now averaging 5.25 percent to 6 percent for 5- and 10-year mortgages. Although these rates are higher than the prior six-month and 12-month averages, they are much lower than average historical rates.

Based on Barron's/Levy historical data, the average 10-year commercial rate during the past 12 months was 5.78 percent, and during the past 5 and 10 years was 6.98 percent and 7.39 percent, respectively.

This historical information is important, because unlike residential real estate, fixed-rate commercial mortgages are not easily refinanced when rates drop.

A borrower that locked into a 10-year rate in 1994 when rates were 9 percent to 9.5 percent is likely still paying that rate because of restrictive prepayment penalties and can only now start to look for a new mortgage at today's rates.

An investor paying off a 9.5 percent mortgage and rolling into a 6 percent mortgage would have an entirely different perspective on the nature of the pending interest-rate storm than RERC.

Nonetheless, a number of investors have not locked into longer-term rates and are open to increases in the shorter-term federal-funds rate. Much like homeowners paying floating rates on their home-equity loans, investors' monthly cash flow will decrease as rates increase. The unprecedented volume of new fixed-rate commercial loans this year is evidence that investors have been weaning themselves from floating rates and locking into the safety of longer-term rates.

On Wall Street alone through the first week of June, U.S. commercial mortgage volume as measured by the issuance of commercial mortgage-backed securities was some $35 billion.

Another $21 billion is projected through the end of July, putting the 7-month total at $56 billion, well ahead of the pace of last year's record volume of $78 billion.

Andrew Little is an investment banker with John B. Levy & Co. He can be reached at alittle@jblevyco.com

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