Today’s post is written by Michael Green, Commercial Loan Originator for Counsel Mortgage Group, LLC.
The Federal Reserve’s recent interest rate cuts have sent a surge of excitement through the commercial real estate (CRE) market. Fed influenced rates have returned to 2018 lows, however, the Fed’s interest rate reductions have little to do with conventional CRE financing activity because most conventional commercial real estate lending is indexed over the 5 & 10 year Treasuries. The exception being SBA 7(a) loans that are indexed to the Prime rate which is normally set within a fixed spread vs. the Fed Funds Rate.
Treasury bills, notes & bonds are global instruments affected by worldwide geopolitical events, not necessarily United States monetary policy, i.e., a legislated rate. The recent spreads range from a low of 1.6% to 2.50% for most CRE properties and continues upward above 2.50% based on the risk profile of the property and the borrower, and other covenants of the loan.
Financing activity is tied to these factors, which have put recent rates in a range of 3.5% to 4.5%. This is still considered an attractive cost of capital, and in most cases provides positive leverage. For example, a not-too-exciting run-of-mill $5mm CRE investment with an initial NOI of 6%, that is leveraged 60% ($2mm/40% equity and $3mm/60% debt) borrowed at 4% interest, has a 6% return on investment (ROI), but as leveraged, has a 9% return on equity (ROE) … a yield enhancement of 50% over the unleveraged acquisition.
With more than sufficient liquidity in the market and strong CRE fundamentals, the now 10-year cycle in the CRE market looks like it has more room to run. But the Fed’s drop in interest rates is probably more of a psychological boost to financing. The capital markets are where to look for clues to the future – what are lenders doing. Keep an eye on the bond market. This market has led less transparent markets by as much as a couple years. The bond market will give you insight into the medium and long term cost of capital (5-20 years for CRE). The Fed largely influences the short end – 2 years and less. When they get out of sync with the public markets, e.g., an inverted yield curve, pay attention. How this resolves to “normal” is significant. Which party blinks first, the Fed or the bond market.
The CRE investment opportunities are apparent; the financing opportunities perhaps less so.
Interested in structuring a loan for your CRE investment, finding a lender for your asset class, circumstance-specific qualifying? Or maybe you just want to consider re-financing an existing loan. Give us a call.
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