How Rising Interest Rates Impact Loan Sizing for Commercial Real Estate

Commercial real estate (CRE) investors often rely on financing to acquire or develop properties. However, the availability and cost of financing depend on various factors, including interest rates. When interest rates rise, the loan sizing for CRE projects can be affected significantly. In this article, we will explore how rising interest rates impact loan sizing for commercial real estate and how to calculate important financial metrics such as DSCR, Debt Yield, and NPV.

DCSR Calculation

Debt Service Coverage Ratio (DSCR) is a metric that measures a property's ability to generate enough income to cover its debt payments. A higher DSCR indicates lower risk to the lender and a greater likelihood of loan approval. The formula for calculating DSCR is as follows:

DSCR = Net Operating Income (NOI) / Debt Service

To illustrate, consider a commercial property with an NOI of $1,000,000 and a debt service payment of $800,000. The DSCR for this property would be:

DSCR = $1,000,000 / $800,000 = 1.25

Debt Yield Calculation

Debt Yield is another metric that lenders use to assess the risk of a loan. It measures the percentage of net operating income that goes towards paying off the loan. The formula for calculating Debt Yield is:

Debt Yield = Net Operating Income (NOI) / Loan Amount

For example, if a property has an NOI of $1 million and a loan amount of $8 million, its Debt Yield would be 12.5%:

Debt Yield = $1,000,000 / $8,000,000 = 0.125 or 12.5%

NPV Calculation

Net Present Value (NPV) is a financial metric that evaluates the profitability of an investment by comparing the present value of the expected cash inflows with the present value of the cash outflows. A positive NPV indicates that an investment is profitable, while a negative NPV indicates that it is not. The formula for calculating NPV is:

NPV = CF0 + CF1/(1+r)^1 + CF2/(1+r)^2 + … + CFn/(1+r)^n

Where:

• CF0 = initial cash outflow

• CF1…n = cash inflows in periods 1 to n

• r = discount rate (usually the interest rate)

• n = number of periods

For instance, suppose a CRE investor is considering a property with an NOI of $1,000,000 and a desired DSCR of 1.2. The investor also assumes an interest rate of 5% and a term of 10 years. Using these assumptions, the investor can calculate the loan amount as follows:

Loan Amount = NOI / (DSCR x (1 + Interest Rate)^(Term in Years))

Loan Amount = $1,000,000 / (1.2 x (1 + 0.05)^(10)) = $7,444,716

If interest rates rise, the loan amount will decrease because the debt service payment will increase, making it more challenging for borrowers to secure financing. For instance, if interest rates rise to 7%, the loan amount for the same property would be:

Loan Amount = $1,000,000 / (1.2 x (1 + 0.07)^(10)) = $6,511,638

The impact of rising interest rates on loan sizing can also affect the amount of equity needed to complete the investment. As interest rates rise, the loan amount decreases, which means the borrower must contribute more equity to achieve the same level of investment.

Conclusion

In conclusion, rising interest rates can have a significant impact on loan sizing for commercial real estate. It is essential for borrowers and investors to understand the impact of rising interest rates on loan sizing and evaluate their investment opportunities carefully to ensure profitability. Calculating DSCR, Debt Yield, NPV, and loan amount can help borrowers and investors make informed decisions based on their risk tolerance and investment goals.