2nd Quarter 2013 Hotline
Southern Industrial Development
by Joe A. Hollingsworth, Jr.
For the last 25 years, we have been a strong proponent of taking “risks” on interest rates on our real estate loans by tying them to floating LIBOR (the London InterBank Offered Rate). While this decision has often been controversial, we have been very positively affected by insisting our rates float with LIBOR versus long-term fixed rates. In the past, our view for being tied to LIBOR was based on: (1) the difficulty of long-term lenders (life insurance companies, etc) to “re-open” the loans for alterations, expansions, or sales of property; (2) the penalty of fixing long-term rates seemed to have too big of a premium putting some projects closer to debt coverage ratio problems and reducing profits; and (3) the penalties to get out of long-term fixed rate deals were often onerous. So, as a policy, we decided instead of paying a premium for the fixed rate, why not use the excess cash flow provided by the lower short-term interest rate to amortize the debt more quickly? Therefore, every year you decrease your exposure to the floating interest rate because of reduced principal.
Now this equation has radically changed. For the first time in 25 years, our opinion is that there is increasing risk in holding debt floating with short-term LIBOR rates. A few of the reasons are as follows. According to the International Monetary Fund, gross US government debt is currently at 107% of GDP. A fiscal crunch will force the central bank to pursue inflationary policies, a situation that’s called fiscal dominance. Running higher than targeted inflation is one politically feasible method for “reducing” the outstanding US public debt. When there is little will to harm domestic voters, politicians might turn to this seeminly harmless way to solve the problem.
With the above said, there is a very possible scenario for major medium-term inflation. Long-term fixed rate lenders have become more aggressive and also more flexible by reducing restrictions and pre-payment penalties to place money in this slow-growth economy. Changing now to a higher fixed interest rate will immediately impact your bottom line by paying a premium over floating LIBOR. However, the premium could be just viewed as insurance against the potential possibility of catastrophic losses from runaway inflation.