It’s said in investment circles that markets have a memory of about 20 years. Lessons learned more than 20 years ago are forgotten. Those of us around during the inflation of the ‘70s are hard pressed to recall the details. Many of the commercial real estate and financing professionals and practitioners during the 2005-2008 run-up to the Great Financial Crisis (2008-2010) are hard pressed to echo the lessons learned, or even the causes. If participation didn’t leave a financial scar, it’s likely faded from memory.
And so here we are – again – with 8+% inflation and the Fed Funds rate at 1%. Quite a wall to climb for Mr. Powell & Company. “Forward guidance” to the market is to expect 50 basis point (b.p.) rate hikes in June, July, etc., possibly through the end of the year. This frequency and magnitude of increase is hardly conducive to a soft landing. Whether the Fed will follow through on the “guidance” or cave as the economy softens remains to be seen. Mr. Powell’s previous behavior suggests the latter, but we’ll give the guy a chance. Stay tuned!
We wrote in this space several months ago about expected lender behavior in this environment, and lo, it has come to pass. We currently know of one lending source of a 25-year term loan with an adjustable rate that will fix for 5 years and a pre-payment penalty schedule that exhausted in 3 years – a very forgiving refinance structure that will avoid rate increases for 5 years. This without costs of interest rate swaps or cap rates on the adjustments. We expect this program to be modified or withdrawn “soon” – it won’t be advertised!
As much as this environment provides risks and borrowing hurdles for borrowers, these conditions provide flip-side challenges for lenders. Their problem is they have too much idle capital – money that needs to be invested (lent). But to protect themselves, they’re forced (by prudent lending standards) to hedge further interest rate increases which seem sure to come. How so?
A simple structure is an adjustable rate loan. Periods of adjustment tend to be intermediate terms, i.e., 3-7 years. Open-ended (no cap on the maximum rate increase at the adjustment terms), the rate increases place the future risk directly on the borrower. Lenders will often offer to place a cap, or maximum, rate increase over the term of the loan, but at an up-front cost to the loan. This is typically booked as a fee to obtaining the loan. Amortizing this fee over the term of the loan, or the term to re-set, can substantially increase the stated rate of the loan.
The other not-so-simple hedge found often in conventional commercial real estate loans utilize a derivative known as an interest rate swap. Those with memory of the Great Financial Crisis may recall much was made of this part of the lending market in attempting to “un-wind” positions to liquidate properties, or even find re-financing values. (The Dodd–Frank Wall Street Reform and Consumer Protection Act enacted in 2010 was to overhaul the financing industry to prevent or correct further such abuses that were uncovered, but sadly, the derivative market is larger today that in 2010, and the banks too big to fail then, are even bigger now.) So, swaps are still in use as financing tools, and if shopping for a loan, you should expect to be presented with a loan structure that may include this as a feature to the loan. That doesn’t make them bad; it’s just a word of caution in analyzing the offering. The price of the swap will bear a relationship to the stated rate of the loan, as well as the term of the loan. Like other terms of a loan, these are negotiable.
The good part of financing CRE today is that the fundamentals of commercial real estate are still attractive – not all segments, and not all geographical markets. How can that be?? Inflation, possible (likely?) recession, Russia-Ukraine war, supply chain interruptions, labor shortages, illegal immigrants surging at the southern border … is COVID 19 still a factor? … and it’s an election year! Yes, given all that, CRE is still attractive. Money is mobile! It seeks the optimal risk:reward placement. Most investors can analyze the reward … cap rate, NOI, IRR, ROE, ROI, etc. It’s assessing the risk that becomes dicey, particularly in today’s environment. And analyzing the loan adds another layer of risk and reward to the process.
Another plus for financing today, lenders are flush. Banks excess reserves on deposit at the Fed are about $3.6 trillion. As interest rates in the market rise, the fixed rate the Fed pays banks on these deposits become less attractive. Hence, the banks desire to put these funds to work. Lenders will build in terms and conditions to protect themselves from future rate hikes, but banks are motivated lenders, and are becoming more so on a day-to-day basis.
We work for you, not for the lender.
Today’s post is written by Michael Green, Commercial Loan Originator for Counsel Mortgage Group, LLC.