How the property industry is measuring interest rate risk

In the same way home ownership in Australia is being impacted by the Reserve Bank of Australia’s interest rate tightening, commercial real estate is experiencing a period of adjustment.

In our changing economic environment, investors and owners are having to more closely examine their existing debt exposures as well as the accessibility of new debt.

Access to leverage is a key part of most investors’ investment strategies. Not being able to lever assets as high as previously possible affects a borrower’s ability to buy new properties, undertake new developments and refinance existing loans. Yet this is the position some commercial real estate players are finding themselves in.

For lenders, the interest coverage ratio (ICR) has become a metric of added focus for sizing new debt facilities as well as monitoring existing ones. While the definition can vary between lenders and facilities, simplistically, the ICR is determined by dividing asset income by interest expense.

In recent months, ICRs have deteriorated significantly while asset incomes (the numerator) have remained stable – a sign that the interest expense (the denominator) is driving the change.

Diving into this further, commercial real estate loan pricing is typically made up of a credit margin added to a base reference rate, which in Australia is generally the 3 Month Bank Bill Swap Rate (3M BBSW). While credit margins for core investment loans have widened on average 20-50 basis points (bps) over the past 12 months, the real driver of gross cost increases is the base rate.

The 3M BBSW has moved from trading in a tight range of approximately 10bps for almost two years when emergency funding measures were put in place at the onset of Covid-19 in March 2020, to commencing its upwards trajectory from April 2022.

Since then, the base rate has moved to around 330bps as of 1 February 2023, reflecting one of the steepest increases since the BBSW benchmark emerged in the mid-1980s. This increase has coincided with inflation shock commencing in the first half of 2022, and the start of the Ukraine conflict. Both have caused increases in wholesale funding costs globally as bond yields and volatility surged.

In this context, loan serviceability and therefore the appropriate level of leverage is the main conversation borrowers are having with their lenders for both new and existing loans.

Source: JLL Debt Advisory, Bloomberg

Back to ICRs, which measures a borrower’s ability to service loan interest payments from their underlying asset (or portfolio) income stream. ICR’s are one of the major debt covenants of loan facilities, and ultimately a gauge of the financial strength and creditworthiness of a particular transaction. For this reason, it requires close scrutiny and monitoring both upfront and during the life of a loan term.

Twelve months ago, ICRs were viewed somewhat as an afterthought for some borrowers as the markets predicted much lower rates for longer, and ICRs were well above minimum acceptable levels.

But most lenders are now sizing leverage as a function of forward-looking ICR’s based on the forward base rate curve and the amount of headroom available. This is especially focal given the interest rate outlook and lenders’ internal and regulatory risk tolerance parameters.

The below graph shows the current and past futures market view of the expected 3M BBSW over the next five years. Note the delta between expectations today and 12 months ago.

Source: JLL Debt Advisory, Bloomberg

Historically, commercial bank lenders have required a greater than 2 x ratio of property income to interest expense for most investment loans.

As an example of the impact of rising rates, consider an asset yielding 5% (ignoring any income growth) and a hypothetical loan with a 2.00% credit margin. As is evident, the ICR while previously exhibiting a comfortable amount of headroom, quickly falls below the typical loan covenant as the base rate increases.

Source: JLL Debt Advisory, Bloomberg

Lenders are cognisant of this, so for the right sponsors and transactions, they are providing some relief by flexing their ICR covenant thresholds to a reduced level of 1.75 x ratio of property income to interest expense, and more recently, 1.50 x.

The net effect is, while it was once possible to lever up to approximately  60% of property value, and even 65% in some circumstances, most transactions are closer to capping out at 55%, with 45-50% increasingly being the new accepted range for core investment assets given the tight yields on some assets. This affects certain investors more than others depending on their individual strategies and equity return hurdles.

As with homeowners, interest rate risk management is now at the forefront of commercial investors’ minds. Considering the exponential cost increases, some investors coming up to refinance or expiry are finding that they may require to de-lever or restructure their positions and at worse be faced with the decision to potentially sell assets.

These adjustments should be seen from the lens that the market is performing a natural and orderly rebalancing. In a lot of respects, borrowers are having to adjust to a new normal, emerging from a ‘Goldilocks’ era of aggressively low interest to one more in line with the long-term average.

Liquidity for debt remains largely strong. Leverage is being tempered as a function of ICRs which should ensure there is a buffer in the system and less likely a chance of a market dislocation should asset values decline materially.

For more information about ICRs, or for help with your debt strategies, contact Josh Erez .