CRE Midwest

Associated Bank's Rotunno: Rising interest rates can be a good thing

Eventually, interest rates are going to go up and that is good. The Federal Reserve Board has said that interest rates will be low for a very long time. However, starting in 2014 they are slowing their bond buying program. Since this announcement, long-term interest rates have risen.

By Jerry Rotunno

Senior Vice President-Associated Bank

Eventually, interest rates are going to go up and that is good.   The Federal Reserve Board has said that interest rates will be low for a very long time.  However, starting in 2014 they are slowing their bond buying program.  Since this announcement, long-term interest rates have risen.

Rising interest rates can be good news.  You may ask: what banker would not think charging more for lending money is not a good thing?  But it is not clear how much of the increased cost lenders will be able to pass on to customers.  Banks, other lenders and investors can be expected to absorb some of the cost.

What would be the effect of increased interest rates on the financing and investment of Chicago industrial real estate?  Taken in isolation, any increased cost of doing business is not a good thing.  However, it can be viewed as a symptom of something good: more robust economic activity.  The United States economy is starting to grow at a faster pace both locally and nationally.

We see good news on the economy everywhere.  On a national basis, the Fed is slowing its bond buying program because unemployment has dropped to 7.0 percent.  New Fed Chairman Janet Yellen predicts a 3 percent growth rate in 2014, much better than the 1.7 percent growth rate for 2013.

At Associated Bank, our Commercial & Industrial Group reports a renewed optimism among its customers.  Companies that have been hoarding cash are now putting it to work by investing in new plant, equipment and employees.   In many cases, they have little choice as their operations are approaching capacity.   Our commercial real estate customers with tenants in manufacturing and distribution, report that their tenants have a new attitude.  They are more likely to expand their space and invest in growing their business.

We should not be too concerned about a measured increase in short-term and long-term interest rates.  The capital markets are prepared for it.   We have prudently acted like we know interest rates will rise, we just don’t know when.

Investable funds, whether equity or debt, are priced off a benchmark index.  For equity and long-term debt, it is the yield on the 10-Year U.S. Bond.  For construction loans it is the 30-day LIBOR rate.  All equity and debt today is priced with investment spreads at near historical highs. If history repeats itself, rising interest rates will result in a lowering of loan and investment spreads back to a more normal level, acting as a shock absorber to the higher index rates.

Institutional investors, as all cash buyers of our local core industrial properties, have built higher interest rates into their pricing models.  The average core industrial capitalization rate is about 6.25 percent today, essentially the same as in 2007.   The 10-year bond yield is 3.00 percent, resulting in a 3.25 percent average investment spread.  In 2007, the 10-year treasury yield was 5.00 percent.  With the same capitalization rates we see today, the average spread of 1.25 percent in 2007 was much smaller.     An improving economy will bring more equity to the market putting more pressure on the investment spread and resulting in little movement in the capitalization rate.

Leveraged private investors will see some effect from rising interest rates.  A recent value-add acquisition of a distribution center in suburban Chicago was priced with a 7.50 percent current return on equity.  The buyer obtained a 5.00 percent interest rate for 10 years which is a 2.00 percent loan spread over 10-year U. S. Treasury Bond Yield of 3.00 percent.  If the 10-year yield were to rise to 4.00 percent, more of net operating income is needed to pay debt service at the expense of the equity return.

How much net operating income will be diverted from equity to debt payments is uncertain and not a straight math calculation.   The 2.00 percent loan spread is near an all-time high.  Some of the increase will be absorbed by the lender in the form of a smaller spread.  So if treasury yields go to 4.00 percent, the loan rate probably increases to something like 5.50 percent not 6.00 percent.  To pay the equity the same 7.50 percent return with this higher loan rate requires a price that is just 3 percent lower.

It is not clear that the buyer will get his 3 percent price reduction.  The improved economic conditions will probably mute the effect.   The equity might take a slightly lower return because in a faster growing economy rent increases are more likely or down time between leases is less.

Higher interest rates will require developers to increase their construction budgets.    Construction lenders use the LIBOR Index as an estimate for their cost of funds and tack on a spread over LIBOR for other costs and a profit.   Unlike long-term loan rates, construction loans are floating rate loans that adjust monthly.   If interest rates rise during construction, the interest payment will increase each month.  In contrast to the 10-year treasury yield, the LIBOR rate has not changed recently.   The current rate of about 0.25 percent is at its lowest level since it was established as the benchmark index 30 years ago.

If a bank sees its cost of funds increase, it will try to pass it on to the customer.  The developer will need to increase the interest reserve line item in the construction budget.  Typically the cost of interest during construction is $2.00 per square foot.

A construction loan interest rate spread of 2.75 percent is typical today for a total interest rate of 3.00 percent.  As with other rates, this spread is near an all-time high.  So if the LIBOR index rises from 0.25 percent to 1.25 percent, the lender may not be able to pass all of its costs on to the developer.   The construction loan interest rate may only increase from 3.00 percent to 3.75 percent with the lender absorbing the rest through reduced spread.     The $2.00 per square foot interest cost would rise to $2.50 per square foot.   With an improved economy and more leasing velocity, a $0.50 per square foot cost increase should easily be absorbed.  That requires less than $0.05 per square foot in additional rent.

Over time interest rates will go up; we just don’t know when.  This will raise the cost of debt.  The capital markets are prepared for this.  Compressing investment and loan spreads will absorb some of the cost.  A faster growing economy will bring greater opportunity and fortune for all of us so that we will overlook the cost of higher interest rates.

Jerry Rotunno is Senior Vice President of Associated Bank in Chicago.   This article was written with the help and insight of Tony Pricco of Bridge Development Partners, Steve Roth of CBRE and Scott McKibben of Brennan Investment Group.