An afterthought when markets were predicting lower rates for longer, one metric is now top of mind for lenders
Guide
How the property industry is measuring interest rate risk
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Source: JLL Debt Advisory, Bloomberg
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.
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 .