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I received a question from a Fidelis limited partner who asked “Does the difficulty in refinancing short-term debt due to high-interest rates and strict lending conditions pose a risk to Fidelis and its investors”
This question was based on a comment I made in my 3rd Quarter CEO Performance Report under the section 4th Qtr. 2023 Outlook, where I said “Borrowers seeking to refinance the existing short-term debt will face challenges in obtaining the desired long-term financing due to high-interest rates and stricter conventional lending conditions.”
So, if one limited partner had this question, more investors might be asking the same thing, so I want to share my answer with all our Limited partners.
What is Interest Rate risk?
Interest rate risk is the potential for financial losses due to fluctuations in interest rates. The predominant risk in the current economic climate is interest rate risk. The Federal Reserve’s rapid increase of short-term rates by 5%+ in a little over a year is extraordinarily fast and unexpected, presenting unique challenges.
The residential housing market’s undersupply of inventory has kept property values stable, effectively reducing any loan-to-value risk. Therefore, the risk of any investor losing any capital from a shortfall in equity is not currently an issue.
The Fed’s swift increase in short-term rates this last year has led to a rise in long-term rates, complicating refinancing existing loans.
Therefore, the main challenge, as I addressed in my report, is the ability of borrowers to refinance their Fidelis loans with long-term debt, especially since interest rates have risen so rapidly.
Many of our loans are secured by properties that are to be sold as the exit strategy, which has been successful due to stable property values, but for the loans that are refinanced with long-term debt, that is where the challenge arises.
How is Fidelis Mitigating this Interest Rate Risk?
Our business model, where we only fund short-term loans, provides a natural hedge against interest rate risks. This is because short-term loans have a rapid turnover, which allows for quick identification and resolution of any underperforming loans, and we currently don’t have any underperforming loans to worry about where any capital is at risk.
We approach loan underwriting by including a margin of error for future rate increases where the debt service coverage could become an issue on those specific loans being refinanced. In this unique situation, with the Fed’s unprecedented rise in short-term rates so quickly created challenges that would normally have been accounted for in our routine underwriting.
Another mitigating factor is that our borrowers typically have the financial resources to cover any financial shortfalls when refinancing, which helps reduce this interest rate risk.
For example, Fidelis funded a $1.8 million loan commitment to convert a single-family residence into a six-unit multi-family property, creating substantial value. The property’s stabilized value now exceeds $3 million, less than a 60% LTV ratio, ensuring there’s more than sufficient equity and virtually no risk of loss in the current market where value remains stable.
However, with the rise in long-term interest rates, the maximum take-out loan available was $1.5 million, falling short by $300,000. In this instance, the borrower has the means to cover this shortfall of $300,000. If this wasn’t feasible, they could always sell the property as the exit strategy, or we have alternatives like issuing an additional $300,000 loan secured against another adequately valued property with a viable exit strategy or modifying the original loan to extend its term, allowing the borrower more time to address the shortfall, so there are various ways to mitigate this challenge.
Therefore, the challenges we face are not about potential capital loss or incurring financial losses, given the stable property values and solid LTV ratios; they involve the loans that are being refinanced, which ultimately affect borrower profits in a sale or necessitate additional cash from the borrower when refinanced.
The Fidelis loans being refinanced are being handled successfully by our borrower’s ability to perform or our ability to restructure the loan with additional security.
In summary, we mitigate interest rate risk with strategic underwriting strategies, leveraging borrower strengths and flexible loan structuring. This multifaceted approach ensures that Fidelis Private Fund effectively steers through these economic challenges. Furthermore, we maintain a healthy loan loss reserve as an extra precaution against future losses if such a thing were to happen.
My commitment is to keep our limited partners informed and engaged, building a relationship based on trust and transparency. I value your relationship and appreciate your investment in Fidelis.