Will Resets to Variable Rate Loans Cause Trouble?
U.S. commercial real estate finance in the recent era of low Libor became a business driven by variable rate loans. Libor, though, has been on a steady pace of increase since early 2016, with a spike in levels beginning in late 2017. Do these Libor trends spell trouble for commercial real estate?
Rates on variable rate loans are often set as a spread to Libor. If Libor goes up across various term lengths, there are two channels where the increases could cause trouble for commercial real estate finance.
The first and simplest channel is that loans may become more expensive. Before 2016, the majority of refinancing activity involved fixed rate loans over longer terms. As commercial property prices climbed, however, investors faced a difficult time making deals pencil out at the return objectives that investors had going into deals. Opting for lower-cost variable rate loans was one way to juice returns.
However, into 2016 more than half of all commercial real estate refinance loans were completed at variable rates, as shown in the chart. Shown here is the 3-month Libor which was below 1% for most of 2016. It has since jumped and stood at an average 1.9% for all of Q1’18. Investments made in 2016 and later are going to face higher debt service costs when refinancing in the future.
Luckily, the sharp upward pace of growth in the 3-month Libor which was seen between Q4’17 and Q1’18 has come to an end. Looking at the higher frequency daily data, the upward pressure on Libor has halted: it trended around 2.3% throughout April and May. Even if lenders reset these loans at the same spreads as before, as long as Libor stays in what is still a low range, refinancing should not be too problematic. Yes, many of these variable rate loans involve interest rate hedges, but the real fear here is if Libor continued the type of spike seen into Q1’18.
The second and more complicated channel is the willingness of lenders to provide capital. The spike in Libor into Q1’18 was accompanied by a spike in the so-called TED spread. This spread is the difference between the 3-month Libor and 3-month US Treasury bonds. This spread grows when investors are fearful of the risks in credit instruments. If investors continued to become more fearful of credit instruments, lenders might be more hesitant to extend loans and tighten up the supply of credit to the commercial real estate markets.
As with Libor itself, however, the spike in the TED spread in Q1’18 narrowed sharply into the first two months of Q2’18. This narrowing suggests that the perception of risk that was growing in the credit markets late in 2017 and early 2018 is easing.
The global economy is moving into a higher interest rate environment worldwide as a variety of macroeconomic forces change. The speed of adjustment is the key issue for the lending markets. On the variable rate loan channel, so long as increases in Libor are moderately paced, lenders and investors can adjust their expectations on pricing without too much difficulty. These investors may also start opting to refinance back to longer term fixed rate loans if hedging interest rate risk becomes too costly.