As interest rates rise, what happens to commercial loan activity?

Fixed-rate commercial loans lock the interest rate for the loan term at a spread, or margin, over an underlying index, such as U.S. Treasury bonds or Federal Home Loan Bank rates.

The majority of fixed-rate commercial loans being originated today and for the last 10 years carry a term of five to 10 years, even though their amortization periods are much longer.

Commercial interest rates have been at historic lows for a number of years, and most investors seeking term loan refinancing for lower-interest-rate purposes have likely refinanced. Prepayment penalties have hampered some of the refinancing activity, but many borrowers simply paid the penalty as the benefits of the lower interest rate outweighed the cost.

Since commercial loans do not typically have a coterminous term and amortization period, there is an outstanding loan balance at the end of the loan term that must be paid back to the lender. Over $250 billion in commercial real estate loans is due to mature within the next three years. Refinancing these maturing loans has and will continue to provide an ongoing source of commercial loan activity, without much impact from increasing interest rates.

The component of commercial loan activity that is more sensitive to rising interest rates is the acquisition loan.

The acquisition of commercial real estate is driven by various factors, including interest rates. Commercial real estate is an alternative investment opportunity that is constantly compared to other investment alternatives, such as stocks and bonds. The demand to own commercial real estate in recent years has been very strong, driven by the attractive yields and the lackluster performance of the other alternatives. This demand has increased sales prices, putting a squeeze on yield with low interest rates contributing as a subsidy, toward achieving those yields.

As interest rates increase, the yields will not be as attractive, and if sales prices do not adjust downward to reflect the increase in interest rates, alternative investments may begin to compare more favorably with commercial real estate. But sales price adjustments will take time to reflect the increasing interest rates.

Within the last 30 days, the indices that establish longer-term fixed interest rates have moved upward in excess of 50 basis points, or half a percent. The impact of the increase has resulted in a jump in interest costs from an average low of 6 percent to 6.5 percent or greater. The benchmark 10-year Treasury yield surpassed the so-called barrier of 5 percent, and many interest rate gurus believe the yield may increase by another 50 basis points during the remainder of this year.

Commercial interest rates are still extremely low on a historical basis, and I do not expect the recent increases to have any significant effect on commercial lending for the remainder of the year. However, if interest rates continue to rise beyond 7 percent and into the 8 percent range, we may begin to see a slackening of demand if sales prices do not adjust accordingly.

All told, 2006 should continue to be a banner year for commercial real estate acquisitions and accompanying financing. The volume may not break the record year for commercial loan funding set in 2005, but all indications are that both lenders and intermediaries are currently experiencing and expecting another great year.

David B. Eaton, president of Eaton Partners, Manchester, manages the firm’s Commercial Mortgage Group. Questions can be submitted to him at Commercialnotes@eatonpartners.com.