800-248-3229 solutions@icbb.bank

Interest Rate Volatility and the Lender’s Response in 20223 | Dev Strischek

For lenders at many community banks, the rising rate environment can be difficult to navigate. At ICBB, we hope to be a resource for community banks in all aspects of their operations. We’ve asked Dev Strischek, principal at Devon Risk Advisory Group and popular speaker at our Annual Credit Conference, to provide information on risk and lending subjects. In this article, Strischek provides practical advice for lenders on navigating interest rate volatility.

That old Chinese curse, “May you live in interesting times,” is timely again as we experience rising interesting rates as the Fed and other central banks have boosted their nations’ interest rates to mitigate inflation.  For many people in the United States, they have not seen any significant movement in rates since the Great Recession back in 2007-2009, over 15 years ago.  The inflation pressure had been building for the past couple of years as the COVID pandemic, supply chain kinks, and the war in Ukraine have all done their part in limiting supplies of goods and services as consumer and business demand has resurged to drive up prices, especially in 2022.

So, the government solution has been to whack the inflation mole with its inflation rate mallet—make borrowing harder by making credit more expensive—to stop people and businesses buying, to depress demand and slow down production, to idle factories and lay off workers, and to complete the cycle by reducing incomes to the point that people and businesses are unable to buy anything.  The solution to inflation seems to be recession.  Ouch.

The Ups and Downs of Interest Rate Volatility

It used to be standard practice for bankers to test a borrower’s repayment ability by jacking up the borrowing rate by 1% or 2% and calculating whether the borrower’s debt service ratio could stand the pressure. This was standard practice until a decade ago, because at that time, interest rates were flat.  One client bank confided to me that it no longer practiced interest rate sensitivity because it was a waste of time, not just in short-term lending but even in long-term financing.  The chief credit officer had given up trying to convince lending management that rates might rise—even his CEO chuckled at the very idea.  The CCO shared with me a couple of months ago that loan review had sampled the bank’s business loan portfolio and reported half of the loans could not debt service in the current rate environment.  I suspect that this bank is not alone.

Nearly forty years ago, a construction industry association asked me to present my views on construction activity, and I predicted that interest rates would probably go double-digit in the next year.  In fact, the prime rate peaked at 22.5%, and construction work plummeted, but I was heralded as some sort of genius.  Of course, I was betting on 10% or 11%, not 22.5%. At 22.5%, there were very few borrowers whose debt service ratio came close to 1.0, unless you permitted the lenders and analysts to round up the results.  The point of this story is not my limited predictive skills but that rates do move.  The evidence is apparent in any graph of interest rates over the last 50 years.  Our problem is that many borrowers and lenders have never lived through interest rate cycles.  However, just because they have not experienced it does not mean it does not exist, so if 2022 has been a wake-up call to credit granters and credit users, better late than never.

Property Values:  Lower NOI, Higher Cap Rate, Lower Value

The general public is probably unaware of the link between interest rates and property values, except that mortgage rates have risen sharply.  Our own home carries a 1.875% 10-year mortgage, and its value has increased 25% since we purchased it 3 years ago.  We watched rates decline to a point where smarter, more prescient real estate acquaintances suggested we lock in, and we took their advice.  Compare that to our 1981 homebuying experience in Florida, when we were congratulated for finding a lender willing to finance our first home in Fort Lauderdale for 15.75% over 30 years! I offer these two examples of further proof that rising interest rates are not a recent phenomenon.   But what does this housing story have to do with property values?

Commercial real estate property values are based on the capitalization of the income generated by the property.  Suppose an office building is generating an annual $1,000,000 net operating income (NOI), and the capitalization rate is 4%, so dividing the $1MM by 4% yields a value of $25MM.  Now suppose rising interest rates reduce the NOI to $900,000 and rising interest rates push the cap rate up from 4% to 5%, and now the property value has fallen from $25M to $18M.  Numerous factors drive cap rates, but rising interest rates reflect more risk, and depending on the type of real estate project, investors will want more return on risky investments.  Given the decline in occupancy rates as more office workers opt to work from home, and the resultant surge in sublet space in urban markets, cap rates have indeed risen.

The Lender’s Response

At the very least, lenders need to dust off their underwriting manuals and reinstall interest-rate sensitivity analyses in their debt-service calculations.  Remember that higher interest rates are going to reduce the income available to cover principal and higher interest costs.  Then, do the same with any real estate that may be collateralizing the loan.  There are plenty of sources for cap rates by property type and by geography, so reduce the property’s NOI by the additional interest expense and apply the current cap rate.

Here is an additional point to consider.  The Financial Accounting Standards Board, (FASB) has implemented lease capitalization to plug the off-balance sheet lease play.  Leases must now be capitalized and entered into a firm’s liabilities.  In addition, the value of the leased asset must be included in the fixed assets as a right-of-use asset.  The good news about rising interest rates is that it reduces the lease liability, but the bad news is that it also reduces the value of the ROU asset, and that reduction might trigger its treatment as an impaired asset.  But that’s a topic for another day, right?

Rising interest rates are an unfortunate byproduct of inflation, and until the Fed’s interest rate strategy runs its course and cools off the economy, rates will continue to increase.  Many of you have not lived through the ups and downs of rates, so I have recounted a few stories of my own experiences with interest rate changes to prove that they have changed in the past and will continue to do so in the future.  I have suggested that you resume interest rate sensitivity in your debt service calculations and incorporate it into your real estate collateral analyses.  Be optimistic because this too shall pass—Mark Twain observed, “Worrying is like paying a debt you don’t owe.”  Go with the flow.

Subscribe to The Correspondent