Interest Rate Risk Rises
California Real Estate Journal
By Mandy Jackson
... The prospect that interest rates will increase eventually - perhaps rapidly if signs of inflation appear as economic conditions improve - exposes commercial real estate borrowers and lenders to risk if mortgage payments rise before property market conditions improve enough to cover higher debt service costs.
"Interest rate risk is something that's shared between the bank and the borrower," said Tracey Seslen, a real estate finance professor at the University of Southern California in the Marshall School of Business and the School of Policy, Planning, and Development. "From the bank's perspective, when they issue fixed-rate loans they're taking on interest rate risk because when the interest rate goes up, they're stuck earning whatever the contract rate on that loan is. When rates go up, they probably won't have higher income for long because the borrower is likely to refinance."
That's why interest rates for fixed-rate loans are higher than adjustable rates when banks originate loans. If borrowers want the security of predictable payments, they pay a premium to lock in their interest rate.
Floating rates are attractive to borrowers who expect interest rates to stay low and anticipate declining income. However, if their income continues to decrease while their interest rate increases, property owners are at greater risk of defaulting on their debt and will have a hard time refinancing to lock in a fixed rate when potential lenders see that the property value has declined.
"Because of what we're seeing with nonperforming tenants and vacancy rates, the exit structure is going to be challenging," Seslen said...