If you’ve recently discussed a commercial mortgage with a lender, you have likely encountered floor rates. As bond rates have sunk lower, they are becoming a regular and necessary part of lending in Canada.
Before we delve into the pros and cons of floor rates, we need to cover some commercial mortgage basics. What do bonds have to do with commercial mortgage interest rates? Many commercial mortgages calculate the interest rate as a spread over a bond yield. The most commonly used is the Government of Canada (GoC) bond with a maturity that matches the term of the mortgage. If you’re entering into a 5 year mortgage, your interest rate would be determined as a spread over the 5 year GoC bond yield. As of today, July 20 2016, that would be 0.65%. Add on a spread of 220 basis points (bps) and you’ve got a 5 year mortgage bearing an all-in interest rate of 2.85%. Spread based interest rates can also be determined by the prime rate, the Canada Mortgage Bond and the somewhat opaque “cost of funds”.
Why floor rates?
So where do floor rates enter the picture? In the example above we calculated an interest rate of 2.85%, which is incredibly low in a historical context. This runs in tandem with GoC bond yields being near all time record lows. This is why many commercial mortgage term sheets will contain language that set a floor rate slightly above 3.00%. This means that even if the GoC plus the spread total an amount is less than 3.00%, the interest rate will not be allowed to go below that.
What value does this create in the marketplace? Don’t borrowers want the cheapest money possible? There are several practical and beneficial reasons to have floor rates.
The primary reason is it keeps liquidity in the debt market. For every property owner that wants to borrow money, there needs to be a mortgage investor to supply the funds. They need to be incentivized through yield to continue investing in mortgages. In today’s mortgage climate, they are seeing yields getting lower and lower. Equity investors see a “tight” property market that only offers them an unleveraged yield on A class product of 3.50% – 6.00%, depending on which asset class they fancy. Mortgage investors must contend with 3.00% returns for the same product, albeit from a safer position in the capital stack. Floor rates help preserve mortgage investors interest in providing capital, and that availability is good for the market.
Dropping cap rates
At every commercial real estate forum, conference or presentation you are likely to see a graph that depicts the gap of cap rates over bond yields and interest rates. Property owners are particularly interested in this graph as it shows the positive leverage they can use to juice up returns by using debt. The gap does widen and shrink over time but its movement generally mirrors interest rates. The further interest rates fall, the further cap rates will fall.
Floor rates prevent interest rates from falling further but they also stop cap rates from declining in response. This may be a contentious point, as those that have already amassed large portfolios would benefit from cap rates compressing. That being said, most would agree that cap rates tightening further does not contribute to a healthy real estate market. At some point in the murky future, interest rates will have to rise and push cap rates back up. The further they have fallen, the messier it will be when they rise. Floor rates are just one factor that can help put the brakes on.
Rising bond rates
You may be thinking that if the mortgage investor wants a 3.00% interest rate, they should just structure the interest rate as the GoC bond (0.65%) plus 2.35% spread to reach the minimum target of 3.00%. This would have the same ultimate cost to the borrower, so why not? What if the world decided that Brexit isn’t such a big deal after all, and bonds were to rise 15 bps prior to funding your new mortgage? Now the borrower’s all-in rate is 3.15%. If a floor rate structure had been used, the same borrower would still have a 3.00% interest rate. The floor rate actually protects borrowers from rising bond rates.
What are the cons of floor rates? The obvious answer is that it could potentially cost a little more to borrower money for your commercial property. Hopefully I’ve highlighted enough positives that you consider it a price worth paying.