Minimizing the Effect of a Rate Hike

By Venture Mortgage

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”?

  1. 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.

  2. 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.

  3. 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.