Since March 2022, the federal funds target rate has increased from 0.25–0.50% to 5.25–5.50%. The increase in the federal funds rate has impacted financial institutions’ loan portfolios, investments, and deposits. Most financial institutions have observed how higher interest rates are affecting loans with variable rates, loans repricing at renewals, and rapidly declining interest reserves on construction loans.
Financial institutions also should consider the effect of higher interest rates on construction loan projects that are underway. These loans were underwritten using borrower projections, appraisal assumptions, and principal and interest (P&I) payments based on the interest rate at the time of the underwriting. Since many large projects have 24-to-36-month construction/lease-up periods, the interest rate at the conversion date could be significantly higher than what was anticipated when the loan was underwritten.
Below is a loan we analyzed that illustrates how an interest rate increase from 4.50% to 8.13% impacts the projected debt coverage ratio (DCR):
| Loan Amount: | $58,017,000 | |
|---|---|---|
| Amortization: | 360 months | |
| Interest Rate: | 4.50% | 8.13% |
| Monthly Pmt: | $293,964 | $430,978 |
| Annual Pmt: | $3,527,568 | $5,171,736 |
| Projected Net Operating Income (NOI): | $5,281,488 | $5,281,488 |
| Debt Service: | $3,527,568 | $5,171,736 |
| DCR: | 1.50 | 1.02 |
| Cash Flow: | $1,753,920 | $109,752 |
As evidenced in the example above, while the NOI does show the ability to service the debt based on the higher interest rate at slightly above 1.0x, it is now below the financial institution’s policy of 1.25x and has significantly lower excess cash flow than was approved. This could result in a policy exception, or a lower risk rating based on the bank’s risk rating definitions.
We would recommend financial institutions consider revisiting these loans, whether it be during annual reviews or specifically targeting this segment of the portfolio, to assess the DCR based the current interest rate. Depending on the results of the initial analysis of the original projections and the new estimated debt service, the financial institution may need to contact the borrower to obtain updated projections or financial information. We have observed instances where market rents have increased since the original projections. This has resulted in an updated NOI that was able to service the new payment. To support these new projections, we have seen financial institutions obtain new appraisals or updated market rent data. A common source we observe for updated market rent data is CoStar. With this current information, we would recommend comparing the original projections, appraisal projections, and new projections to the new estimated payment. This will allow a financial institution to fully document the current state of the project and the repayment ability using the new debt to correctly identify and support the risk rating.
For more information or assistance with loan review, please reach out to a professional at FORVIS today.