It is no longer a question of if rates will rise. Now it’s a matter of when and by how much.
In our last post we discussed the prospects of higher mortgage interest rates and their potential effect on the pricing structure for industrial real estate, particularly for owner/user properties.
The rate for the SBA 504 loan, the one most commonly used in owner/user transactions, has already increased from 2.62% in December of 2020 to 3.59% in February of 2022. That’s a 37% increase in interest expense in 14 months. While it is true that the low 2.62% rate was at least partially in response to the pandemic, math is math and the impact of the subsequent rise is as real as it gets.
An interesting and important fact is that the entire increase over that time occurred before the Fed raised its Fed Funds Rate at all, which it has made clear it will do several times in 2022. Thus far, it has wound down its bond-buying to stem the release of newly manufactured dollars into the economy that has contributed to the current spike in inflation. First things first. When that program ends in March, the Fed’s rate hikes will begin, and some Fed officials have signaled an initial bump of 50 basis points to put markets on notice that they are serious about tackling inflation. That is likely to send the yield on the 10-Year Treasury bond, the benchmark index for mortgage rates, up along with it. The real adventure will begin there as we venture into the unknown.
Concerning? Yes. Scary? Also a yes because low interest rates have been a key driver of our current pricing structure, along with low supply. For owners, the fact that low supply will continue is the good news. For buyers it just adds another layer of difficulty to the acquisition process. It’s going to get even more expensive to buy property that is already nearly impossible to find. That is until rates rise enough to crimp demand enough to send prices into decline. In our view, it will take a further significant increase in mortgage rates to crimp that demand, as it is currently running way out in front of supply and prices are still on the rise.
So, let’s do the math using the rate increase that has already occurred to further make our point. Let’s say that you own a 20,000-square-foot building that you are thinking about selling because you are concerned about a looming market correction and you are getting ready to retire. Let’s assume your building is currently worth $375 per square foot (no, that’s not a typo).
Here’s what the deal would look like to a potential buyer who plans to use the SBA 504 program to acquire the property using the mortgage rates from 14 months ago as compared to today’s rates.
|Conventional 1st T.D @ 50% LTV||$3,750,000 @ 2.75%, 25-year term, $17,299/month|
|SBA 504 2nd T.D @ 40% LTV||$3,000,000 @ 2.62%, 25-year term, $13,640/month|
|Total Monthly Payment||$30,939 or $1.55/square foot/month|
|Total Interest Cost in Year 1||$179,369|
|Total Interest Cost over 25 years||$2,531,904|
Here’s the same deal at today’s rates:
|Conventional 1st T.D @ 50% LTV||$3,750,000 @ 3.80%, 25-year term, $19,382/month|
|SBA 504 2nd T.D @ 40% LTV||$3,000,000 @ 3.59%, 25-year term, $15,163/month|
|Total Monthly Payment||$34,545 or $1.73/square foot/month|
|Total Interest Cost in Year 1||$247,380|
|Total Interest Cost over 25 years||$3,613,807|
These numbers even surprised us when we ran them. The difference in cost is stunning to say the least, and this is before the first Fed bump in the Fed Funds Rate! In this example, your buyer would pay over $68,000 in additional interest just in the 1st year and $1,081,903 more in interest over the life of both loans. One wonders at what interest rate would the buyer no longer be your buyer, and how many other potential buyers would be discouraged enough to stay on the sidelines. If rates rise just another 100 basis points, which is distinctly possible, things will look much worse and makes talk of a market correction more believable.
Our intention here is not to scare, but to inform. The numbers are the numbers and we want to make sure you take them into account as you plan your exit strategy. For now, it’s advantage seller and the scarcity of available property is keeping prices moving up. But, every cycle has a top and history has shown us that a big shift in monetary policy can be the exogenous event that creates it.