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Commercial Real Estate Loans and the Impact of Rising Interest Rates on Commercial Real Estate

Posted by Media Relations on Monday, August 1st, 2005 - Comments »

Pacific Security Capital, a leading commercial real estate investment bank, addresses the impact of rising interest rates on commercial real estate loans.Beaverton, OR, August 1, 2005 http://www.pacificsecuritycapital.com — Pacific Security Capital (“PSC”), a leading commercial real estate investment bank, headquartered in Beaverton, Oregon, addresses the impact rising interest rates could have on commercial real estate loans and the commercial real estate market overall.There has been no shortage of conversation surrounding the topic of rising interest rates in the commercial capital markets over the last two years. Mike Myatt, Executive Managing Director of Pacific Security Capital explains that “the reason for all the column fodder is that interest rate movement has a direct impact on the state of capital markets supply and pricing and can have a very real impact on the overall commercial real estate market.”As a baseline for a deeper analysis it is useful to have a macro-economic understanding of what happens to property level supply and demand drivers and the resultant impact on Net Operating Income (NOI) in a rising interest rate environment. As a general economic principal when interest rates rise the cost of new construction increases thereby slowing the number of construction starts and depleting new supply of product coming online. This scenario in turn causes an increase in overall market absorption rates and creates a “landlord’s market” environment.Myatt adds that “the environment which favors the landlord creates an opportunity for property owners to increase rents thereby allowing NOI growth to keep pace with any escalation in interest rates. While this scenario is favorable to existing property owners and making the rise in interest rates less of a concern, the impact to developers and tenants is detrimental and can have a negative overall impact on the economy if a high interest rate environment lasts for any length of time.”At a more micro level some of the major issues surrounding the impact of increasing interest rates on commercial real estate loans and commercial capital markets are addressed below:Flow of Funds: In a low interest rate environment real estate provides a reasonable investment alternative to other low yielding asset classes. With rising interest rates the supply-side availability of capital marked for commercial real estate will constrict. The aforementioned contraction will be due to a combination of reduced demand for new supply as weaker developers are weeded out of the market and alternate investment opportunities in other asset classes begin providing a better yield while being perceived to have less risk when contrasted to commercial real estate investments.Loan Pricing, Sizing and Cost of Funds: The overall blended cost of capital will increase dramatically. This dramatic increase will come not only as a result of rising rates across underlying indices but moreover as a result of lower advance rates in the senior position shifting a higher percentage of the capital structure up in the leverage curve. The reduction in LTV and LTC advance rates will cause a borrower to rely more heavily on mezzanine and equity financing resulting in shift from the current “borrower’s market” climate to a “investor’s market” environment.Investment Sales: Sales of investment grade properties will slow rapidly as many of the buyer’s in today’s low interest rate environment will move to the sidelines. Institutions and REITS will remain active buyers while many of the individual investors will be forced from the investment sales market. Default rates will climb and more distressed property will come onto the market as investors who leveraged up on floating rate debt during the low interest rate environment will have a hard time keeping control of property as their debt service obligations increase.Commercial real estate owners who believe that interest rates will rise substantially and will remain elevated for any period of time should be looking to refinance short-term commercial real estate loans, floating rate debt with long-term fixed rate debt. Buyers looking to acquire investment property should look for assets with upside potential for NOI growth through improved management and upside pop in leasing opportunities.About Pacific Security Capital Pacific Security Capital is a leading commercial real estate investment banking firm providing commercial real estate loans, structured finance, investment sales and advisory services. The combination of direct lending, advisory, intermediary, corporate and professional services, syndication and acquisition services consistently allow PSC to rank among the leaders in the industry. PSC is headquartered in Beaverton, Oregon with other offices in major markets in North American and Europe. More information about the company can be found at www.PacificSecurityCapital.com###

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