Rising interest rates, meant to tame inflation, are posing a series of challenges to local banks hoping to fund new commercial loans. 

While lenders began 2021 anticipating some interest rate increases this year, the changing rate environment in recent weeks has added another challenge to commercial real estate lending. 

Issues ranging from higher costs to supply chain issues and labor shortages have already affected the dynamics of commercial real estate deals. While still reporting strong activity in several sectors, lenders could face potentially rapid changes in the months ahead.  

“Rate, while very important in many transactions, is simply one of the challenges facing commercial real estate today,” said Stephen DiPrete, chief commercial banking officer at Weymouth-based South Shore Bank. “My only concern as a banker is the speed of the rise – it doesn’t allow you to prepare much.” 

Rates Remain Low 

Lenders entered 2022 following an active year in commercial real estate. While the number of office space projects seeking financing has been limited during the pandemic, local banks report strong demand to finance multiple property types, including apartment buildings, industrial spaces, mixed-use buildings and for-sale housing developments. 

Massachusetts saw about 3,770 commercial real estate purchase loans last year, an increase of 31.2 percent over 2020 and 15.9 percent over 2019, before the start of the pandemic, according to The Warren Group, publisher of Banker & Tradesman. 

Lenders also had an active year for refinancing, with 6,700 commercial real estate refinance loans in 2021 compared to about 6,500 in 2020 and 2019. 

After beginning last year with another round of Paycheck Protection Program lending and the PPP forgiveness process, traditional commercial lending picked up in the second half of the year, said Brian Bullock, executive vice president and chief commercial lending officer at Lowell-based Enterprise Bank. 

The market has remained active, Bullock said, even with rising rates. With the Federal Reserve signaling frequent rate increases this year, banks will use the tests they already run during the underwriting process to see how rising interest rates will affect prospective borrowers and their ability to make principal and interest payments, Bullock said. Other factors for commercial real estate buildings, such as vacancy rates, will also be considered. 

Bullock noted that rates remain low, especially when compared to past decades. While the benchmark federal funds rate just saw a 0.25 percent increase following the Federal Reserve’s March meeting, Bullock pointed out that banks often base longer-term rates on the Federal Home Loan Bank of Boston’s rates, which in some cases have risen about 1 percentage point in recent months. 

Perspective for Borrowers 

While rates have moved higher than their historic lows, maintaining perspective is a top priority when speaking with customers, said South Shore Bank’s DiPrete, noting that rates remain low compared to just a few years ago.  

Refinance activity has already been affected by the rising rates, DiPrete said, while demand for new loans has not yet been affected. Rising rates will add to discussions around financing new projects, which already face other pressures, DiPrete said.  

“I can’t remember a time when rates, cost, labor, supply chain and duration of project have negative trends,” DiPrete said. 

Banks and customers will need to look at the effects of higher rates, DiPrete added, including whether banks will accept lower rates, putting pressure on their margins, and how borrowers might attempt to offset other costs, by charging tenants higher rents or seeing reduced profits. 

Banks will also need to clearly communicate strategies with customers to help them manage risks. 

“There are financial products that deal with managing interest rate risk, so your relationship with your banker, your discussions with your banker, should include, ‘How do I manage my risk in a rising rate environment,’” DiPrete said. 

Opportunities for Creativity 

Since lenders use rates to determine how much cash flow a company might support and how much leverage they are able to obtain, the pace and magnitude of rate changes create challenges for lenders and their customers, said Robert Brown, executive vice president for commercial real estate at Brookline Bank. 

“It’s challenging to understand what’s going to happen tomorrow or the next day or the next Fed meeting,” Brown said. 

The current rate environment does give banks and borrowers opportunities to work creatively, Brown said, to figure out risks borrowers might be willing to take with their debt, including short-term variable rates, which are often lower but might increase, or locking in rates for longer terms.  

“[Borrowers] understand what their objectives are,” Brown said. “Given how volatile the rates are, some of those objectives could be jeopardized if the rates move against what they’re anticipating.” 

Brown added that the prospect of rising rates has led borrowers in the past month to start looking into how long banks would be willing to lock in fixed rates. 

Mitigate Costs 

Rockland Trust Co. has already seen an increased demand from clients to protect against rising interest rates, said President and Chief Commercial Banking Officer Gerry Nadeau. 

“We want to make sure that our borrower doesn’t face a situation where a spike in interest rates puts the repayment of the loan at risk, and conversely, the client is equally concerned,” Nadeau said. 

Some clients think that rates will likely spike and then come back down for the long term, Nadeau said. These borrowers will purchase an interest rate cap, where the rates will float but only up to an agreed upon maximum rate that the borrower and bank think can be absorbed. 

Other borrowers, not convinced that rates will come down, want more interest rate certainty, Nadeau said, and will use derivative contracts such as swaps. Based off the Secured Overnight Financing Rate (SOFR, a successor to LIBOR), the contract lets the borrower swap some or all of the loan principal for a fixed rate. A structured swap lets the borrower add to the swap on a regular basis. 

“If you can’t mitigate the risks of construction costs, or you can only partially mitigate them, then try to mitigate interest rate risks, because those are the two things that can hurt you most,” Nadeau said. “It’s a very challenging time.”