Forward rate lock - A solution for developers in the real estate industry? - by Stuart Gelb

A mortgage rate lock is an agreement between borrower and lender that allows borrowers to lock in an interest rate. If you're looking to borrow, here are a few key things you should know:

Facts: In the last three decades, inflation has been relatively low in the US economy. Inflation has averaged over 1-1/2 percent over the last decade. 

Problem: With the inflation rate at 8.5%, the Fed is moving interest rates to slow the economy down. Why is this a problem for developers in the construction space today? When the developer goes to borrow funds on a specific project, the rates are typically variable and will change monthly to much higher rates. With the additional costs of labor and materials, this will add substantially to the cost of the project. 

Most construction projects go on for 24 months or more and only upon stabilization can they get their perm financing based on the state of the 10-year treasuries at that time. That pricing today is unknown and is projected to be much higher. Major effects on the size of the loan, DSCR (debt service coverage ratios), the annual cost of the loan, and will have a negative effect on all ratios. Debt yield, Cash flow, Cap rate, ROI (return on investment), ROE (return on equity), LTV (loan to value), IRR calculations. At certain levels unknown to the investor/developer today, the actual project may not be profitable to execute and will not be known at the point of receiving the construction loan. 

Solution: Forward rate locks that are set up with swaps Banks can use these derivatives to safely lock in rates for their clients. There are very few banks doing “forward rate locks” today in construction. This gives the opportunity for the developer to lock in a forward rate lock on the permanent financing when closing on their construction loan. Typically, the lock is in place for 8 years after the 2-year construction comes after completion and stabilization. At minimum, one can pencil in the costs of financing and be comforted that the deal makes sense. 

Stuart Gelb is the CEO of The Liquidity Source New York, NY.