Christopher T. Arnold (ctarnol@peoples.com) is vice president and manager of the New Haven, Conn., region of the People’s Bank Commercial Real Estate Finance Department.

In the past few years, to a great extent, the commercial real estate market has been fueled by interest rates hovering at 40-year lows. These rates have led to enhanced cash flow and increased property values. Capitalization rates in the 7 percent to 8 percent range for high-quality properties have not been uncommon.

But with interest rates rising approximately 100 basis points during the recent April-to-June period and future increases likely – it is more important than ever for both lender and borrower to move quickly and to structure a transaction that is acceptable to both parties.

So what will be the likely effect of rising rates for both the lender and the borrower?

From the real estate lender’s perspective, the primary focus is to evaluate and understand where increased debt service may compromise cash flow. Lenders routinely perform interest-rate sensitivity analysis on their existing loan portfolios, stress testing cash flow for various assumed increases in rates. In addition, many lenders utilize “hurdle rates” for underwriting, testing a borrower’s ability to service the debt based on an assumed fixed-interest rate that is higher than the interest rate for which the borrower is currently applying. This provides the lender with comfort that if rates do increase, there is some built-in cushion.

The seasoned lender and investor have experienced numerous market shifts and understand that a long-term perspective is essential to success in the real estate market. A rise in rates will present opportunities as well as the obvious challenges.

The savvy lender/investor will seek to take advantage of these opportunities. The ability to execute quickly, for example, becomes an extremely important competitive advantage in a rising rate environment. A lender’s untimely response can cost a client significant money, which is why you should deal only with a financial institution that can respond to your application quickly and definitively upon receipt of the requested financial documentation.

A Chance to Shine

There are a variety of commercial mortgage products tailored to managing risk in a rising interest-rate environment. Rates with various term election options, variable rates with caps and forward rate locks represent just several such products.

Let’s consider a scenario that demonstrates the importance of these products: A client is seeking to submit a winning bid on a commercial property in a quickly changing rate environment. To be as competitive as possible, the client’s offer provides for a sizeable initial deposit and stipulates closing within 60 days. Assume that the seller accepts our client’s offer. Performing by the contract closing date and controlling rate now become critically important.

Since the client’s significant deposit is at risk, it is essential that he develop a quick understanding of exactly what loan structure and pricing the lender can provide.

It is important the lender discuss with the client his objectives for the property. What is the client’s intended hold period? Is early prepayment of fixed-rate debt a likely possibility? Is a lower-rate, short-term product more attractive? Are there capital or tenant improvement expenditures needed in the near term? If so, how will they be funded? Is there a desire to earn out additional loan proceeds?

Let’s assume the client’s investment horizon is 10-20 years. His primary concern is likely to avoid any further increases in fixed rates. This can be accomplished with the purchase of a forward rate-lock agreement. This agreement guarantees the borrower will get today’s rate until an agreed-upon future date – in this case 60 days. If, under another scenario, the client’s assumed anticipated hold period is just five years, he may consider a low-rate, one-year adjustable product and purchase a cap to set a maximum limit to which the rate could increase.

These are but two examples of the options to be considered in our hypothetical scenario. In the best of all possible worlds, the client would consult with his accountant, attorney and lender early on in the process to ensure that each has a suitable comfort level proceeding with the deal. A sure-footed transaction, executed in timely fashion, can be a win-win for both the investor and lender.

It is when there are changes and/or uncertainty in the market that the best lenders truly distinguish themselves. A client’s financial advisor needs to provide the expertise and responsiveness that secure success. This, in turn, can result in customer loyalty, repeat business and referrals for the lender.