It is a familiar story. As the storm clouds of rising interest rates and widening credit spreads gather overhead, borrowers run for the cover of floating-rate, mini-perm loans to wait for the sunny days of low rates and easy, long-term money that are just around the corner. Or are they?
After enjoying a nearly steady tightening of rates and spreads between 1995 and the fall of 1998, developers who gambled on rates since then by not locking up permanent takeout financing for construction projects now face significant profit erosion.
Since September 1998, Treasury rates have soared 175 basis points (bps) and swap spreads have widened 45 bps from 85 to 130. This trend has translated into a rise in financing costs for commercial properties of more than 200 bps. The Federal Reserve has raised rates six times (over 175 bps) since March 1999 in an attempt to slow the economy and reduce inflationary concerns. While the Fed may or may not raise rates again, it clearly will not be lowering rates for the foreseeable future.
While "rate gambling" is always dangerous, it is particularly risky for properties net-leased to credit tenants. Unlike multi-tenant real estate properties where rolling leases can be renegotiated to keep up with market conditions, credit-tenant leases have fixed rents and long terms. Since developers often sign fixed-rate leases with credit tenants 9 to 15 months before a project is complete, their ultimate profit is dependent on interest rates and the cost of financing. When rates and/or spreads rise during the construction period and the developer has not arranged a fixed-rate exit strategy, the developer faces a loss in equity value.
The impact can be dramatic. For example, a $10 million credit-tenant loan originated only nine months ago would only provide a borrower $9.4 to $9.5 million in loan proceeds at today's spreads and rates, sharply reducing the return on the project.
Risks of mini-perms Faced with today's rising interest rates and spreads, some developers are "doubling down" on their interest rate bet by turning to floating-rate, mini-perm financing. With this strategy, developers are obviously hoping that interest rates will fall. This strategy, which may be effective for a traditional real estate transaction, is unfortunately a potentially more costly and risky option for credit-tenant leased properties where the owner has no ability to adjust rent or lease terms.
On a macro level, while interest rates have risen in the past 12 months, by historic standards they still remain low (please see chart). Only three times in the past 30 years has the absolute level of interest rates been lower. While the Federal Reserve tightening is expected to eventually slow the economy, there are no guarantees that the economy will slow sufficiently in the next 12 to 24 months to result in rates dropping low enough to offset the real cost and risks of a mini-perm financing.
The costs and risks include credit risk for their tenant, potentially increased short-term financing costs, lack of liquidity and increases in fees and expenses, all the while making an interest rate bet.
Analysis of risk Mini-perms for credit tenant-leased properties subject the borrower to various "event" risks associated with the credit tenant. The risk for potential credit downgrades or negative assessments by the rating agencies or investors is the most prominent of these risks. While no one expects his credit tenant to be downgraded - corporate ratings can be downgraded even in the best of economic times for a variety of reasons, ranging from poor operating performance to tenant acquisitions.
In a weakening economy (which may coincide with a drop in rates), the likelihood of failing corporate profits and downgrades increases. Since investors and CTL lenders are highly sensitive to how the rating agencies view a particular credit or industry segments, borrowers could find themselves with a Rite Aid, Eckerd, Winn-Dixie, or Dillard's type credit situation where they either can't finance their property in a CTL transaction or can only finance it at significantly wider spreads.
In addition to "buying time" in hopes that rates and spreads tighten, borrowers are often drawn to mini-perms because they believe the rate to be substantially lower than a fixed-rate permanent loan. The current market for a two-year, mini-perm for a CTL loan is based on 90-day LIBOR plus 200 bps, or approximately 8.1%, while a 20-year, fixed-rate CTL loan might carry an interest rate of 240 bps over the 10-year Treasury, or 8.6%.
Additionally, the CTL rate is fixed while the borrower bears the risk that short-term rates continue to rise, resulting in his floating-rate financing cost increasing. That's not a significant "savings" when measured against the risks assumed and the opportunities lost by opting for a mini-perm rather than maximum permanent fixed-rate financing.
A mini-perm is essentially the same as financing a CTL property today with a fixed-rate permanent loan and using the proceeds to buy U.S. Treasury securities to preserve the interest rate bet. This strategy has several advantages over a mini-perm: There is no credit downgrade risk; no spread risk; no extra fees or legal expenses and loan proceeds will be higher than they would under a mini-perm.
Further, Treasuries are liquid, allowing the borrower to quickly "lock in" a return by selling the Treasury when rates are where he wants them to be. While this is clearly a better approach for an owner seeking to finance a credit-tenant leased property, it is doubtful whether a developer would invest his permanent loan proceeds in Treasuries in hopes to make money on a future drop in rates.
Developers are much more likely to invest their loan proceeds in their next deal. The question for the borrower is: If they wouldn't speculate in the Treasury market if they already had the cash, why would they opt for a mini-perm with all the inherent risks and costs embedded in this approach?
Yet another factor that a borrower must weigh when opting for a mini-perm financing is cost. A borrower is likely to have to pay two fees if he chooses a mini-perm, one for the mini-perm and the other when he arranges permanent financing. These fees could add 12 to 15 bps to the real cost of the mini-perm - to say nothing of the added legal cost of two closings.
Beyond the risks and economics of mini-perms for credit-tenant properties, a developer who chooses mini-perm financing is tying up his source of capital - generally from his construction lender. Additionally, mini-perms are typically recourse loans, which further increase the risk to the borrower. (Parenthetically, the mini-perm lender is not only taking on all the borrower risks outlined above, but additionally since most mini-perms are "interest only," the permanent loan takeout amount will be reduced by two years cash flow because the new loan amount will be based on the present value of the remaining stream of net rent properties during the term of the lease.)
Mini-perms have seductive appeal to risk-taking entrepreneurs hoping for a return to the good-old days when rates were close to their 30-year lows. The problem for the developer is that the long-term, fixed economics of credit-tenant leases do not mix well with mini-perm financing.
A better strategy may well be for the borrower to lock in his development profits by arranging his permanent loan at the same time as setting the rent for the credit tenant. One way to accomplish this task is through a forward-rate-lock takeout or through a "one-time close" construction/permanent loan, thereby ensuring that the profit he bargained for when he signed his lease will be there when the project is complete.