By Venture Mortgage

*How To Insure Your Assets Against A Rate Hike…Just In Case*

*How To Insure Your Assets Against A Rate Hike…Just In Case*

Not sure if the fed is going to raise rates soon? Well, I’m not either, and anyone who claims otherwise *is probably not being honest with you*. I have, however, given some thought to helping my clients insure their assets against a future rate hike...

Is there a way to obtain insurance against a rate hike? The answer is **yes**, in the form of* long term, fixed interest rate debt*. However, it is important to examine the costs associated with this insurance, so let’s run some numbers.

For the purposes of this example, we will assume that you are a long term holder, are in the market for debt, and are comparing **5-year debt to 10-year debt**. Here, a 5-year interest rate is 3.90% and a 10-year rate is 4.25%. Our loan amount will be **$5 million with amortization of 25 years, 75% LTV and 7% cap rate.**

Should you pay more in interest for the security of knowing your rate is fixed for a full 10 years, or should you take the lowest rate, get more cash flow for the 5 year term, and take your chances with the refi in year 6? In other words, what is the cost of securing longer term fixed-interest rate “insurance”?

Debt service for the

**5-year deal at 3.90%**will be**$313,399**annually. At the end of the five years your remaining loan will be**$4,347,500**.Debt service for the

**10-year deal at 4.25%**will be**$325,043**annually. At the end of 5 years, your outstanding balance will be the same as with the 5 year deal, but after 10 years your remaining balance will be**$3,554,800**.Your

**savings on debt service**realized by taking the 5 year deal would be**$11,644**annually for five years (followed by uncertainty at refi time!). That is real money…*Vikings season tickets for 4 plus popcorn*! Let’s call that $58,220 total your insurance premium, paid for the security of the 10 year deal with the rate at 4.25%.

What does that $58,220 protect you from? Most obviously, you are protected against a substantial increase in interest rates: in the event that you refinance with another 5 year loan after the first 5 year loan matures, the new interest rate can go up to 4.73% before you would be worse off. It is important to note that this analysis assumes no additional financing costs for the refinance; typical financing costs range from 1% to 2%, so a more realistic hurdle rate might be approximately 4.60% (assumes 1% cost to refi).

Another consideration is that as interest rates rise, capitalization rates generally also rise, which results in decreased asset values. Therefore, a second risk that you would be insuring against would be a substantial increase in cap rates during the initial 5 (and the resulting lower property value). In the event that the capitalization rate was higher at the time it came to refinance your 5 year loan, assuming a constant NOI, the cap rate could go up to 8.05% before your loan to value on the then outstanding balance would be above 75%. This higher LTV will be a definite obstacle to securing capital at the time of refinance.

In a more stable market, this long-term fixed rate insurance may allow you to sleep more soundly. In a dramatically rising interest rate environment, however, it may very well be the difference between keeping and losing your asset.