Dissecting the Impact of Increased Borrowing Costs on the US Government and Real Estate Industry

Who Will Survive The Higher Rate Environment For Longer?

Part I: The Real Estate Industry?

Over the past year, interest rates have risen, resulting in a substantial curtailment of fixed and floating-rate real estate lending activity. While the current interest rate environment may still be favorable when considering historical trends, the rapidly increasing borrowing costs have created significant challenges for real estate companies. Many borrowers who are not immediately facing loan maturities are choosing to delay transactions in the hopes of future rate declines or stabilization.

This trend raises concerns about the future of the lending landscape in the real estate industry.

Setting the Stage

To comprehend the impact of increased borrowing costs, it is crucial to analyze the market overview. As of October 10, 2023, the 10-year Treasury yield stands at approximately 4.6%. When combined with the average spread added by lenders, this results in all-in interest rates for 10-year commercial mortgage-backed security (CMBS) loans of around 7.2%. On the other hand, the one-month term Secured Overnight Financing Rate (SOFR) sits at 5.31%. After factoring in spreads, all-in interest rates for floaters can reach the high 7.0% range.

Comparing these rates to early 2022, when the Treasury yield was less than 2% and the one-month term SOFR rate was 0.05%, it is evident that interest rates have experienced a significant spike.

Impact on Underwriting

The increased debt service payments resulting from higher interest rates pose challenges from an underwriting perspective. In most cases, property incomes have not kept pace with the rising cost of borrowing, making it more difficult for properties to meet the debt service and debt yield hurdles required by lenders. Consequently, deals that are still being executed often involve reduced loan proceeds, additional structures such as debt service reserves and active cash management systems, and shorter terms, reflecting the hope that rates will drop in the coming years.

Given these circumstances, the underwriting process has become more critical than ever. A thorough legal review of loan terms is essential for both lenders and borrowers to protect their interests in this high-interest rate environment.

New Cost of Hedging Products

Rising interest rates have also led to an upsurge in the cost of hedging products, particularly interest rate protection agreements. These agreements act as insurance policies, paying out if the identified benchmark, such as SOFR, exceeds a certain level during the term of the agreement. Floating-rate lenders commonly require these agreements as a condition for granting loans. As SOFR rates continue to rise, the counterparties responsible for providing insurance under these agreements face increasing payouts, leading to a significant spike in the price of these hedging products.

Reports suggest that the average cost of purchasing an interest rate protection agreement is now ten times higher than it was just a year ago. This surge in costs further exacerbates the financial burden on borrowers in the commercial real estate sector.

Impact on Commercial Lenders

The combination of factors mentioned above has resulted in a significant decline in commercial lending activity. For instance, compared to 2021, CMBS issuance dropped by approximately 36% in 2022, reaching $70.2 billion. Similarly, collateralized loan obligation (CRE-CLO) issuance, primarily associated with floating-rate lending, decreased by approximately 33% to $30.3 billion. Although lending activity has shown a slight increase in the second quarter of 2023 due to stabilized interest rates, the Federal Reserve's indication of potential rate hikes may impede the return of a vibrant commercial lending market.

Impact on Borrowers

With an estimated $162 billion of securitized commercial mortgages reaching maturity in 2023, many borrowers are likely to seek extensions or modifications to preserve more favorable interest rates. However, lenders are likely to demand additional structures, such as reserves or cash management systems, in exchange for such extensions or modifications. This reflects the cautious approach lenders are taking in the face of the current high-interest rate environment.

Part II: The Impact On The US Government

The United States government is facing a significant challenge in managing its debt. The growing debt burden has led to increasing interest payments, creating a debt spiral that could have far-reaching consequences for the country's economy.

Interest Payments As A Growing Percentage Of GDP

In September 2023, Treasury Secretary Janet Yellen emphasized the importance of the net interest as a share of GDP metric in assessing the US fiscal health. Currently, at 1%, the Congressional Budget Office predicts that interest payments will make up 6.7% of GDP by 2053, surpassing Social Security as the largest federal expenditure by 2051. Furthermore, the CBO estimates that US debt as a percentage of GDP will reach a new record this decade, peaking at 107% in 2029 and potentially hitting 181% by 2053. Interest payments already exceed federal spending on youth education and are projected to surpass defense spending in four years. Yellen warns that this alarming trend could lead to a stagnant economy, limited investment in areas like national security, and increased borrowing costs as interest rates rise.

Understanding the Debt Spiral

The debt spiral refers to a situation where a country's debt levels continue to rise, leading to an unsustainable cycle of borrowing and debt repayment. In the case of the US government, this debt spiral is fueled by the growing interest payments on its existing debt. As the debt increases, so does the amount the government must pay in interest, putting further strain on its finances.

Stages of a Debt Spiral

There are several stages in a debt spiral:

• Increased Debt Levels: This could be due to overspending or inefficient tax collection.
• Market Concerns: Markets start worrying about debt levels leading to higher bond yields (higher interest rates).
• Higher Debt Servicing Costs: Rising debt increases debt interest payments.
• Government Action: Governments need to cut spending and increase taxes to reduce bond yields.
• Recession: Trying to reduce debt can lead to a recession.
• Struggling Economy: The shrinking economy means it's harder to meet debt repayments.
• Default: The government struggles to meet interest payments and markets no longer want to buy more government debt, leading to partial or total default.

Conclusion

The repercussions of heightened loan expenses on property assets have been substantial. Escalating interest rates have posed hurdles for proponents, diminished the profit from lease revenues, and amplified the stringency of underwriting examinations. In addition, the price of risk management options has skyrocketed, leading to a dip in lending operations. As the pace of activities decelerates and with an influx of billions of dollars expected to mature this year, the real estate sector has experienced an instantaneous impact from the surge in rates compared to the US Government's capacity to manage its snowballing debt. While the effect of climbing interest rates on the US Government's ability to honor its debts is consequential, the wider economy is yet to witness a slowdown akin to what the real estate industry is currently facing. Thus, it seems that in this era of high-interest rates, the US Government will endure for longer, before the repercussions permeate into the economy and the fiscal plan.

SOURCES

https://finance.yahoo.com/news/us-debt-interest-payments-unsustainable-203001849.html

https://www.economicshelp.org/blog/5118/economics/debt-spiral-explained/?

https://finance.yahoo.com/news/top-economist-paul-krugman-says-220948126.html?

https://www.bloomberg.com/news/articles/2023-09-28/government-shutdowns-default-threats-fuel-america-s-debt-spiral?

https://www.forbes.com/sites/digital-assets/2023/10/01/flashing-red-warning-33-trillion-us-debt-death-spiral-could-suddenly-trigger-a-bitcoin-price-vicious-circle/