The slow-burning impact of rising rates

The Bank of England’s decision last week to raise the UK base rate by 0.25 percentage points to 0.75 percent will, in isolation, have minimal impact on the commercial real estate lending market.

Rates, after all, have been historically low for a decade and the Bank’s decision merely points them towards more normal levels. The Monetary Policy Committee stressed the likelihood that any future increases, if the economy develops broadly in line with its expectations, will be implemented at a gradual pace and to a limited extent.

There are good reasons why economists from within the commercial property market have played down the Bank’s latest decision. As Walter Boettcher of Colliers said, the commercial property market remains only modestly leveraged, hence loan coverage ratios should not feel too much pressure.

As many have been quick to point out, property yields do not correlate directly with interest rates, so capital values will not necessarily fall as rates rise. In addition, sterling Libor remains below 2012 levels, meaning most borrowers’ cost of debt remains within their comfort zones. The reality is, rates would need to rise sharply to spark a genuine crisis in the property lending market.

However, the UK rate rise should not be dismissed as a non-event. The future path of interest rates in the coming few years should be giving real estate debt market players pause for thought, if not the odd sleepless night. In a long-term appraisal of the commercial real estate debt space, a tightening of monetary policy on a national and global level is among the most important factors.

That does not mean rising rates spell doom. But a gradual end to the era of bargain debt will affect lender and borrower strategies alike. Higher base rates increase the cost of funds for banks and other financial institutions, which are typically passed on to borrowers through increased lending costs.

While many lenders have factored in the rising cost of money, such as five-year swap rates, to their stress tests, they may become more cautious about who they lend to if they fear a correction in values in certain parts of the market could lead to a deterioration in interest cover and debt-yield ratios.

Given a refinancing spike is expected in 2020, borrowers and lenders need to consider potential changes in market conditions. The 2017 Cass Business School report on UK lending noted £28 billion (€31 billion) of unhedged floating-rate loans, accounting for 18 percent of the market, for instance. Potential rate rises will be on the minds of lenders and borrowers of that debt.

Consider also how crucial the global low-rate environment has been to real estate as an asset class. If property’s relative value to alternative investments such as corporate bonds narrows, upward pressure on property yields could result.

Certainly, last week’s rate rise needs to be seen in perspective. It was widely expected and unlikely to have caused too many headaches in the property debt market. As the Bank has indicated, a sharp rise is not likely, looking ahead. Even in the US, where the Fed raised rates for a seventh time in three years in June, property people argue the stronger economic outlook prompting the increases is keeping the real estate market afloat.

The UK’s quarter-percent hike will be comfortably absorbed by the real estate market, but it should serve as a reminder that interest rates will, over time, creep up to a new normal.

Email the author: daniel.c@peimedia.com