By Kevin Young
With interest rates at historic lows and the economy performing well, the United States is at a crossroads with regard to fiscal policy – the outcome of which may significantly alter the financing capability of businesses across the country. Interest rates have a massive effect on the borrowing and leasing capability of owner-operators, midsize businesses and multinational corporations alike. The Federal Reserve influences market interest rates by adjusting the federal funds rate, which is the interest rate at which private banks can exchange reserves at the central bank. Consequently, the federal funds rate influences borrowing, purchasing and leasing activity in the economy at large.
Federal Reserve officials met on Dec. 16 and 17 and announced that they will not likely keep the federal funds target rate at 0-0.25% for much longer. In fact, many economists and bankers forecast that rates could go up as soon as June 2015. Although the initial hike is expected to be small – 0.25% is likely – any rate hike would start to place upward pressure on the market prices of financing services for commercial mortgages, projects and equipment, thereby eroding buyer leverage and potentially reducing demand in these markets. Furthermore, once a rate hike is initiated, history tells us that more are likely to follow.
Commercial mortgage financing
Long-term financing is poised to be the most affected by a change in fiscal policy. Commercial mortgages typically involve large principal amounts, requiring loans from one or more commercial banks that are directly affected by the federal funds rate. When the federal funds rate increases, so does the cost of borrowing for commercial banks, which then pass such costs to borrowers in the form of higher interest rates. According to figures published by the Federal Reserve, the effective federal funds rate fell from 0.1% to 0.09% in the past three years, which IBISWorld estimates led to a 1.4% decrease in commercial lending rates overall. On account of future interest rate hikes, IBISWorld projects that the “price” of commercial mortgage financing services (i.e. commercial lending rates) will increase 16.5% per year on average from 2014 to 2017. Typically, long-term financing is disproportionately affected by interest rate hikes because lenders incur more risk about future changes in interest rates with a long-term loan. Consequently, financing costs will increase significantly for real estate investment trusts, developers, foreign parties and other commercial mortgage seekers.
Project financing services
Businesses, utilities, and municipalities use project financing services to help secure funding that is needed to build out large construction projects. The pricing model for project financing services can involve a mix of consulting fees, equity issuance, and debt financing. Because debt financing is a key component of most project financing endeavors, the amount a client has to pay the supplier depends heavily on prevailing interest rates. With the federal funds rate expected to start increasing in 2015, the costs incurred by project finance lenders are expected to go up. In addition, a resurgence in investor confidence for long-term projects, a growing number of businesses being formed and a steady stream of infrastructure projects will all push up demand for project financing services over the next three years. As such, IBISWorld forecasts that the price of project financing services will increase at an annualized rate of 7.1% from 2014 to 2017.
Equipment financing services
Equipment financing services cover smaller dollar amounts and shorter life-spans than commercial mortgage and project financing services, with agreements typically spanning fewer than five years. The shorter the term, the better the lender can forecast movements in market interest rate throughout the duration of a loan. As a result, the market price of equipment financing services tends to be lower with shorter-term loans. Regardless of the length of the equipment financing agreement, the interest rate charged is tightly correlated with the federal funds rate and prime rate, i.e., the interest rate charged by banks to their largest and most creditworthy customers, which is closely linked to the federal funds rate. Because both are expected to increase over the next three years, IBISWorld forecasts that the price of equipment financing services will grow at an average annual rate of 5.5% during the period.
While the exact timing of a federal funds rate hike remains uncertain, certainty lies in the fact that the prices of financing services will increase significantly when the rate hike does occur at some point in 2015. From 2014 to 2017, IBISWorld forecasts that the prime rate will increase 2.2 percentage points. As the cost of borrowing rises and monetary policy of the Federal Reserve tightens, demand in the financial sector will eventually slow as mortgage, construction and equipment financing prices rise.
On the other hand, a recent drop in commodity prices (especially oil) has generated some deflationary worry, causing some members of the Federal Reserve to voice their intention to continue holding interest rates at historical lows for a longer period, which could keep down the price of financing well into the future.
For now, companies and government agencies are able to obtain commercial mortgage, project and equipment financing at historically low prices. As such, buyers may benefit from financing in the near future before interest rates rise, as is expected over the three years to 2017. With the federal funds rate near zero in 2014, the price of these services is likely to trend upward in 2015 and beyond as the economy continues to grow at a steady clip.
Kevin Young is a procurement analyst for IBISWorld.