Landlords Struggling to Cover Hedging Costs as Interest Rates Increase

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

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According to a 2019 report by the Mortgage Bankers Association, nearly half of all commercial property debt is floating rate. Lenders usually require that these borrowers hedge against an increase in borrowing costs by entering into a derivatives contract known as an interest-rate cap. This type of contract limits a borrower’s exposure to rising interest rates.

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When interest 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.

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Now, many of those contracts are expiring when mortgage rates are significantly higher and the cost of this protection has increased dramatically. 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.
These additional costs can quickly eat up a year's worth of rental income. This can be a real problem when it comes time to pay up.

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Many real estate owners may not have the cash to cover the new rate cap. 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 sell their building than spend millions on the new rate cap. That, he said, could turn into a "first trigger" pushing down real estate values.

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"The real estate industry is facing a margin call," Mr. Gigliotti said.

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Interest-rate caps can help borrowers avoid paying any additional interest payments beyond a fixed threshold. However, the need to renew this protection is an emerging threat throughout the commercial real-estate industry, particularly in the more speculative corners of the property market. Here, investors borrow short-term, floating-rate debt with plans to fix up apartments, offices or retail space and raise rents quickly.

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Landlords are facing difficult choices as they try to address concerns about rising interest rates. They can pay expensive new hedges when their current ones expire, or come up with cash to set aside as protection against further increases. They could also choose to sell their properties into a challenging market, or try to refinance their loans at a higher fixed rate.

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In 2020, apartment owner Investors Management Group took out a $24.4 million loan at a 300-unit apartment complex in San Antonio. The loan had a 5% interest-rate cap that cost the firm $22,000, said Karlin Conklin, the firm’s principal.
The current cap will expire in September, at which point Ms. Conklin estimates that purchasing a new two-year hedge will cost $1 million. This cost is approximately 40% of the property’s annual net income.

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"Paying back your investors would mean taking away from your potential return," she said.

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Ms. Conklin said that her company is likely to either sell the property or refinance at a fixed rate, rather than paying for the new cap.
According to Manus Clancy, an analyst at real-estate debt securities data firm Trepp, 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.

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He said that nobody was really anticipating something where they were going to have to rebuy a cap at the very moment when rates might be peaking.
As interest rates rise, many borrowers with floating-rate mortgages are finding themselves in a bind. In order to keep their monthly payments manageable, they are forced to put money into an escrow account to pay for a new interest-rate cap when the old one expires. This is becoming a financial headache for many borrowers, brokers and investors say.

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The amount of money that property owners set aside for future repairs and maintenance depends on the expected cost of those repairs, and is reset 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 repairs and maintenance has surged, according to brokers and investors.
"This is causing huge problems," said Mr. Duley.

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For investors looking to buy property on the cheap, the current interest rate environment presents an opportunity. With rates expected to stay low for the foreseeable future, now is a good time to lock in a low rate on a new investment property.

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Harbor Group International has recently signed a contract to purchase three Texas apartment buildings from an owner who is under pressure to sell due to an expiring interest cap, said Jacob Slone, a managing director at the real estate investment firm. He expects that there will be more such opportunities in the future.
He said that people will be forced to sell.

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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.

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Without any extension options available, property owners either have to renew their caps at a much higher cost, or pay the full interest rate, according to Mr. Gigliotti.
"In real estate, deadlines are often not firm," Mr. Gigliotti said. "However, this is a real deadline."