(5 Min Read)
Analysis on Corporate Real Estate & Why It's in Shambles
To be clear we are focusing on the reality of corporate real estate right now and not your home. We are talking about the building you walk in everyday, sit at your desk and order Panera. Not the suburbs or the local 7/11.
Corporate real estate loans are different animal when compared to the mom & pop mortgage. The house you grew up in most likely has anywhere from 10-30 years at a fixed rate hopefully around 3.5%-5.0% interest rate. Every year you pay the same rate on the principle and eventually own the house. Simple enough, the interest rate does not change.
CRE (Corp Real Estate)
The main issue with CRE is the "Floating-Rate Debt."
A type of debt where the interest rate can changes over time, not fixed like the earlier one. Say you borrow $50 million using floating-rate debt, the interest payment either goes up or down. This is out of your hands, once you're in you're in. Largly dependent on how well the economy is.
How do you measure if the economy is doing well or not. Typically interest rates - as we've discussed before stronger economy -> more demand -> higher inflation = higher rates (generally). For corporate real estate the name of the interest rate used tied along is the LIBOR Rate. Since inflation has soared, LIBOR rates have soared to combat. Not so good for CRE, which is tied to this rate.
Company has a $50 million floating rate loan with an interest rate of LIBOR + 2%..
Meaning whatever the interest rate on the loan is equal to the LIBOR rate plus 2%.
Likely these loans were taken out with the LIBOR rate near 1%, the environment of interest rate in the previous years. Meaning, the interest rate on the loan was 3% (1% + 2%). This means that the company would have to make an annual interest payment of $1,500,000 ($50 million x 3%) or $125,000 per month.
Now, let's say that the LIBOR rate has increased to 5%. This means that the new interest rate on the loan is 7% (5% + 2%). The company's annual interest payment increases to $3,500,000 ($50 million x 7%) or roughly $292,000 per month.
More than double what is was.
To make matters worse
Let's say you forecasted in this 3% original interest rate. Along with a rate of return on the building at 6%. Leaving us with 6% - 3%. Simply, once you pay your 3% interest, you have 3% left over for all other expenses and then profits.
However this isn't the case anymore, factoring in the now 7% in Interest Payments on a project with an average return of 6%. In a best-case scenario of 6% - 7%, we realize a loss of 1% on 50 million dollar. $500,000 now in debt.
Now factor in a a recession begins to hit and you are now forced to do lay offs, cut costs, economy slowdowns, and are left with 4.5% gain on the building rather than the originally forecasted 6%.
The math now-
Interest Payment: 7% or 3.5 million
Return on Project (ROI): 4.5% or 2.25 million
Net Loss - 3,500,000 - 2,225,000 = 1,250,000