Rising Interest Rates Hit Landlords Who Can’t Afford Hedging Costs

Rising Interest Rates Hit Landlords Who Can’t Afford Hedging Costs

The cost of insuring commercial real-estate loans against a rise in interest rates has exploded over the past year, raising the prospect of a market selloff since many property owners will no longer be able to afford these hedges.

About one-third of all commercial property debt is floating rate, according to a 2019 report by the Mortgage Bankers Association. Lenders usually require that these borrowers hedge against an increase in borrowing costs, through a derivatives contract known as an interest-rate cap that limits a borrower’s exposure to rising interest rates.

When rates were very low, the cost of this insurance was minimal. The cap on a multimillion-dollar mortgage could be had for as little as $10,000. These hedges saved real-estate owners millions of dollars by limiting their exposure to rising interest rates in 2022.

Now, many of those contracts are expiring when mortgage rates are significantly higher and the cost of this protection has skyrocketed. In some cases, renewing this protection at the old interest rate now costs 10 times as much as it did 12 months ago, analysts and brokers said.

When it comes time to pay up, these additional costs can wipe out a year’s worth of rental income.

Many real-estate owners may not have the cash for it. Michael Gigliotti, co-head of JLL Capital Markets’ New York office, said he expects an increase in property sales this year from owners who decide they would rather get rid of their building than spend millions on a new rate cap. That, he said, could turn into a “first trigger” pushing down real-estate values.

“This is the margin call on the real-estate industry,” Mr. Gigliotti said.

The sting of higher rates comes at a time of increasing weakness for much of the commercial real-estate market, which has been battered by fears of slower economic growth and by investors looking for more attractive yields from safer investments, like corporate bonds.

The rise of remote work and layoffs in the tech and finance sectors are undermining demand for office space, forcing landlords to offer generous incentives to fill empty space. The U.S. office vacancy rate was 12.3% at the end of the third quarter, around where it stood at its peak during the global financial crisis, according to data firm CoStar Group Inc.

Even top-performing categories, like multifamily, face new challenges in the year ahead. Apartment rents rose at record levels during the pandemic but are now cooling off amid a wave of new supply that is expected to limit rent growth.

Real-estate owners may also be less likely to borrow money for new construction projects or to renovate existing properties this year, because of both higher rates and concerns about a recession. Commercial real-estate borrowing will fall 5% across all sectors in 2023 compared with 2022, according to estimates from the Mortgage Bankers Association.

Interest-rate caps enable a borrower to avoid paying any additional interest payments beyond a fixed threshold. The need to renew this protection is an emerging threat throughout the commercial real-estate industry, but it is of particular concern in the more speculative corners of the property market, where investors borrow short-term, floating-rate debt with plans to fix up apartments, offices or retail space and raise rents fast.

Addressing these concerns leaves landlords stuck with only difficult choices. Property owners could pay prohibitively expensive new interest-rate hedges when the current ones expire, or come up with enough cash to set aside as a protection against further increases in floating rates. They could instead choose to sell their properties into a challenging market. Or they could try to refinance their loans at a higher fixed rate because borrowing costs have roughly doubled over the past year.

In 2020, apartment owner Investors Management Group took out a $24.4 million loan at a 300-unit apartment complex in San Antonio, with a 5% interest-rate cap that cost $22,000, said Karlin Conklin, the firm’s principal.

That cap will expire in September. Ms. Conklin estimates that purchasing a new two-year hedge then will cost $1 million, which is about 40% of the property’s annual net income.

“You can’t pay it, because if you pay it you’re pulling a lot of the return away from your investors,” she said.

Her company will likely either sell the property or refinance at a fixed rate instead of paying for the new cap, Ms. Conklin said.

While floating-rate loans are the norm in many situations, some real-estate owners in this predicament could have borrowed at fixed rates, but chose to bet that rates would stay low as they had for years, said Manus Clancy, an analyst at real-estate debt securities data firm Trepp.

How do you see the high cost of insuring loans against rising interest rates affecting the commercial real-estate market? Join the conversation below.

“Nobody was really anticipating something where they were going to have to rebuy a cap at the very moment when rates might be peaking,” he said.

In many cases, interest-rate caps are becoming a financial headache long before they expire. Floating-rate mortgages on apartment buildings insured by Fannie Mae or Freddie Mac often require borrowers to put money into an escrow account to pay for a new cap when the old one expires, brokers and investors say.

How much money they set aside depends on the expected cost of a new cap, and resets every six months, said Marcus Duley, chief investment officer at Walker & Dunlop Investment Partners Inc. In recent months, property owners across the country have been getting letters telling them to put more money in escrow because the expected cost of buying this protection in the future has surged, according to brokers and investors.

“It’s causing tremendous issues,” Mr. Duley said.

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For investors looking to buy property on the cheap, the dilemma around interest-rate protection presents an opportunity.

Harbor Group International recently signed a contract to buy three Texas apartment buildings from an owner under pressure to sell because his interest cap was expiring, said Jacob Slone, a managing director at the real-estate investment firm. He expects more to come.

“Are people going to be forced to sell? The answer is yes,” he said.

When property owners struggled to pay off their loans during the worst days of the Covid-19 pandemic, lenders often agreed to extend loans. That helped prevent a fire sale in many cases, stabilizing markets.

But with expiring caps, no such extension options exist, Mr. Gigliotti said. Property owners either have to renew at a much higher cost, or pay the full interest rate.

“Deadlines are almost never deadlines in real estate,” Mr. Gigliotti said. “This is one of the real deadlines.”

Write to Will Parker at will.parker@wsj.com and Konrad Putzier at konrad.putzier@wsj.com

Corrections & Amplifications
Floating-rate loans account for about one-third of all commercial real estate debt, according to a 2019 Mortgage Bankers Association report. An earlier version of this article incorrectly said that floating-rate loans made up nearly half of commercial real estate debt. (Corrected on Jan. 17)

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