We’ve endured the endless bombarding of “up-to-the–minute” news, “news-alerts”, and “this just in” for what seems like, dare I say, forever! And this doesn’t even include the onslaughts to those of you who stay glued to your hand-held devices for the never-ending tweets and hashtags. And the hot topics of the days gone by remain: trade tariffs, inverted yield curves, not if, but now when the next recession will hit, speculation about the Fed’s policies and whether the next FMOC meeting will raise, lower or hold pat on the Fed Funds Rate. The response of markets adjusting to the next shoe that drops seems instantaneous.
So many dots … how to connect them given that they keep changing? Unless you’re a 10-minute trader on E-Trade, you don’t. But clearly the news cycles have become opioids for the markets, this reflective most easily by considering the extreme volatility.
The volatility seen in public financial markets reemphasizes the security of CRE (commercial real estate). The recent financial market swings reiterate both the stability of commercial real estate and the attractive debt yields offered by this asset class. In addition, the exceptionally low interest rates currently available provide a highly-levered yield premium on a risk-adjusted basis for CRE. The recent average combined CRE cap rate of 6.3% exceeded the 10-year Treasury by 480 basis points (4.8%), one of the widest margins this cycle. Key to obtaining CRE enhanced by leverage is the financing used.
Current CRE investors look at declining interest rates with one eye, and their current loans with the other, anticipating refinancing when the current declining cycle bottoms … “then I’ll do it!” they say. This was the case in 2007 & ’08 when the Fed started us down the road to ZIRP. Some of you may remember. But borrowers also need to keep a 3rd eye on lenders. A funny thing happens when rates decline, especially if rapidly. (This typically in a recessionary environment, whether formally called or not.) As the economy weakens and rates keep dropping, banks are busy raising the bar on their underwriting standards! When rates get so low that you can’t wait to refi, you find that banks (and other lenders) have essentially stopped lending!! Banks especially may advertise “low” rates, perhaps 2-3%. And applications may come pouring in, but sadly no body qualifies! Now you’re stuck with that now-high-priced older loan at the bottom of the cycle until the economy recovers and the interest rate cycle clicks up again.
There isn’t exactly frantic lending yet, but the movement is afoot to get loans out the door before then next ¼ point (or ½ ?) rate drop. Declining and low interest rates also eat into banks margins. You may think rates are low, but banks can tell how low by the spreads. If the spread on any particular type of loan gets too thin, the lender will discontinue that loan. When the lending market went illiquid in 2009 it wasn’t because there was no money available. The Fed had been flooding banks with money through the various QE programs. The banks simply cycled the money (quietly) back to the Fed in excess reserves – no loans were made, and the economic recovery languished. The banks couldn’t afford to lend in the poor economic environment at the low-to-no spreads at the time. Hence the recovery waned. (Too bad it took the Fed several years with variations of the theme to figure this out. Maybe they’ll do better next time … but it’s still the same Fed!)
There’s a saying in markets that nobody sells the top, or buys the bottom … it’s just a saying. But the same can be said for refinancing a loan. Generally speaking, if you can make an incremental improvement in the debt component of your investment that otherwise makes sense, you should look at that pretty hard. The nature of the improvement may be quantitative or qualitative, and the acceptable level of incremental improvement is a judgement call. Bear in mind also that the rate is only one of the many terms and conditions of a CRE mortgage. Be sure you consider ALL the covenants.
Maybe you’d like to review this with a practicing professional? I think we have one or two in the office. Care to talk?
COMING IN OUR NEXT COMMERCIAL EDITION:
WHY AN INVERTED YIELD CURVE IS GOOD FOR FINANICNG CRE
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Today’s post is written by Michael Green, Commercial Loan Originator for Counsel Mortgage Group, LLC.
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