Lenders Brace for Interest Rate Increases

Underwriting tightens as banks, intermediaries prepare for the future.

By Jeff Shaw

The consensus is in: expect more stringent loan terms and higher interest rates than we’ve seen in recent years. Although predictions of increasing interest rates have been discussed for years, 2018 appears to be when those forecasts come true.
“For the ninth or 10th straight year we’re saying that interest rates are going to go up,” says Ross Holland, vice president with Ohio-based financial services firm Lancaster Pollard. “It looks like that is finally going to come to fruition.”
The Federal Reserve has indicated it plans to increase rates at least three times in 2018. The first of those increases occurred on March 20, when the Fed increased its benchmark interest rate from 1.5 percent to 1.75 percent.
The comments came as Holland was moderating a panel at InterFace Seniors Housing West, held March 1 at The Omni Hotel in downtown Los Angeles. The panel — which was titled “Capital Markets Update: Who’s Lending and For What Deals?” — attracted nearly 400 industry professionals.
Other panelists included Brian Heagler, senior vice president and senior banker with KeyBank’s healthcare group; Stuart Oswald, senior vice president and managing director with NorthMarq Capital; Dague Retzlaff, senior vice president of real estate with Capital One; and Tim Bernier, executive director of healthcare credit and underwriting with Oxford Finance.
“We really haven’t looked at interest rates for as long as I can remember, so this is the first time in six to seven years where we’re actually focusing on it,” said Retzlaff. “We are starting to look two to three years down to road at what that will look like.”
Capital One is preparing for the rate increases by incorporating more hedges in deals to manage to a higher level of risk.
“We’re going to be a little more conservative on leverage, and we’re going to be a little more conservative on recourse financing,” said Retzlaff.
Bernier said Oxford is also looking for ways to cushion itself against risk.
“We are starting to see LIBOR increases. As LIBOR goes up, we’re looking for ways to be more creative so debt service can stay at levels where the operators have time to transition properties,” says Bernier. “For the first time in eight or nine years, we are seeing our interest rate sensitivities get pretty tight.”
The London Inter-bank Offered Rate (LIBOR) is the benchmark used for construction financing. In March, the 12-month LIBOR rates hit 2.5 percent, well above its year-earlier mark of 1.8 percent.
Fannie Mae and Freddie Mac also are tightening their belts, according to Oswald. Previously, half of Freddie Mac’s production was in refinancings with a starting interest rate around 3.5 percent and a rate cap of 5.5 percent, explained Oswald. Those types of favorable loan terms are starting to disappear.
Still, Oswald sees many lenders (particularly Fannie and Freddie) tightening their spreads to continue generating business. This could be a risky play, as the eventual rise in capitalization rates will trail behind the interest rate increases.
“Spreads are down 50 to 60 basis points from last summer, and in the near term we may not see the big jump in cap rates that some people are expecting,” said Oswald.
Holland agreed that cap rates will probably trail behind interest rate increases, which could be a problem in the acquisitions market. Buyers need to prepare for this market change by increasing the cap rate they seek.
“There will be a transitional period where there is a disconnect; as [interest] rates continue to creep up, cap rates tend to be a little bit stickier,” said Holland.
“So you’re going to have groups that maybe buy assets at today’s cap rates and should’ve probably priced it for tomorrow’s interest rates. That could be an issue for all of us.”
Up to now, the industry has not seen the full effect of these rate increases, but savvy lenders are currently preparing for that eventuality.
“We’ve been waiting for higher interest rates. Now it’s here and we’re trying to figure out exactly what to do with that,” said Heagler. “It hasn’t really impacted the underwriting yet, but it’s certainly coming.”