Navigating the Impact of High-Interest Rates on Commercial Real Estate
Office demand decline, a rocky banking sector, and high-interest rates are just a few of the challenges commercial real estate investors are currently facing. As a commercial real estate owner, your focus should be on the capitalization of your investment. One significant aspect of this is managing debt. The New York Times recently reported that more than half of the US’s $2.9 trillion commercial mortgages will need to be renegotiated by the end of 2025. Unfortunately, in a high-interest-rate environment, refinancing investment properties can be challenging and complex.
Below are tips for commercial real estate investors for navigating today’s tricky financial landscape.
The Impact of Increased Borrowing Costs on Commercial Real Estate
Interest rates play a critical role in investment real estate financing. When rates are high, it can significantly impact the value of properties and the ability of owners to refinance their debt. Higher interest rates equate to higher monthly payments, a strain on the cash flow of a property and thus test the limits of debt service coverage ratios. This increased cost can also make it harder to secure financing for new projects, limiting growth opportunities.
High-interest rates can create significant problems with debt service coverage ratios (DSCR) in commercial loan documents, which are used to measure the borrower’s ability to generate enough cash flow to cover the loan payments. In a high-interest-rate environment, the cost of borrowing increases, and as a result, the borrower may have to make larger loan payments to cover the same principal amount. This can have a direct impact on the DSCR because it reduces the amount of cash flow available to cover operating expenses and other debt obligations, such as property taxes and insurance premiums. If the DSCR falls below a certain threshold, the lender may consider the borrower to be at risk of default, which could trigger a series of events that could lead to the foreclosure of the property.
The DSCR is typically calculated by dividing the borrower’s net operating income (NOI) by the total debt service (TDS). If the borrower’s NOI falls below the required ratio, it means that the borrower is not generating enough cash flow to cover the loan payments and the cushion required by the lender, which can be a major red flag.
When interest rates rise, the commercial real estate borrower may have to pay more in interest payments, which can reduce their NOI and, therefore, their DSCR. This can be particularly problematic for borrowers who have a fixed-rate loan, as they may not be able to renegotiate the terms of their loan until it comes up for renewal. As a result, they may have to pay a higher interest rate for the entire duration of the loan, which can make it difficult to maintain a healthy DSCR.
High-interest rates can create significant problems with debt service coverage ratios in commercial loan documents. Borrowers may find it more difficult to generate enough cash flow to cover their loan payments, which can put them at risk of default. As such, it is essential that borrowers carefully consider the impact of interest rates when negotiating their loan terms and work with their lenders to find a mutually beneficial solution.
Another significant impact of high-interest rates is the potential decrease in commercial property values. This can occur when investors demand a higher rate of return, causing them to look for other investment opportunities. If property values drop, it can be difficult for owners to refinance or sell their commercial properties, especially if they have significant debt.
Loan-to-value (LTV) is a ratio used by lenders to determine the amount of money they are willing to lend based on the value of the commercial property. In a high-interest rate environment, LTV can be impacted in several ways.
Firstly, high-interest rates can make borrowing more expensive, which can reduce the amount of money that lenders are willing to lend. This means that borrowers may have to put up a larger down payment or provide additional collateral to secure the loan.
Secondly, high-interest rates can also impact commercial property values. When interest rates are high, borrowers may be less willing to purchase properties, which can reduce demand and cause property values to decline. This can result in a lower appraised value for the property, which can impact the LTV ratio.
Another way in which high-interest rates can impact LTV is through the timing of the appraisal. When interest rates are high, financial institutions may be less willing to lend, and as a result, appraisals may be delayed. If the appraisal is delayed, it may reflect a lower property value, which can impact the LTV ratio. In a high-interest rate environment, lenders may also be more cautious about lending to borrowers with higher LTV ratios. This is because higher LTV ratios increase the risk of losing money in the event of a default. As a result, the lender may require an even higher interest rate, larger down payments, or additional collateral to offset this risk.
Commercial real estate investors should carefully consider the impact of interest rates when negotiating their loan terms and work with their lenders to find a mutually beneficial solution. A savvy attorney and financial professional can assist in providing and crafting more palatable loan terms.
Navigating the Refinancing Process in a High-Interest-Rate Environment
Given these challenges, it’s essential to approach the commercial real estate refinancing process in a high-interest-rate environment with care. Here are a few tips to keep in mind:
Start early: Commercial real estate refinancing can be a lengthy and complex process, so it’s important to begin acting as early as possible. By beginning the process well before your current commercial loan debt is due, you can avoid last-minute scrambling and take advantage of opportunities as they arise.
Keep an eye on the market: Interest rates fluctuate regularly, so it’s important to keep a close eye on the market. By monitoring trends and changes, you can make informed decisions about when to refinance a commercial loan.
Consider alternative commercial financing options: In some cases, traditional bank financing may not be the best option. Alternative financing options such as private lenders with more flexible terms and less covenants or increasing equity capitalization.
Work with professionals: Refinancing a commercial property is a complex process, and it’s critical to work with professionals who can guide you through it. An experienced attorney can help you navigate the legal aspects of refinancing, while a financial advisor can provide valuable insight into the financial implications of your decisions.
Refinancing commercial real estate debt in a high-interest-rate environment can be a difficult process, but it’s not impossible. By understanding the impact of interest rates on your properties and approaching the refinancing process with seasoned advisors, you can successfully manage your debt and maintain the financial health of your investments.