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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   August 2013

Get Ready for the Post-QE Ride

Develop origination strategies for a new era with less Fed support

Get Ready for the Post-QE Ride

In the aftermath of the financial crisis, the Federal Reserve System stepped in to stimulate the economy with three successive rounds of quantitative easing (QE). The impact of this Fed action has affected the commercial mortgage market in two important ways. First, QE has pushed index rates down to historic lows. Second, it has created an unusually aggressive bid for agency- and government-guaranteed mortgage paper. Spread compression — especially in certain assets such as agency multifamily — combined with low rates have created an unusual environment for commercial mortgage origination.

This past June, the Fed indicated a possible end to the QE stimulus, rattling the market and leading commercial mortgage brokers — as well as other industry professionals — to wonder what the ride will be like when rates shoot up and push them outside the past few years’ comfort zone.

Although banks and other loan investors have excluded certain geographic locations and property types categorically because of their underperformance in the recession, borrowers and property types generally have fallen into two types:

  • Conventional: Borrowers and properties that can secure financing at historically low rates and spreads
  • Unconventional: Borrowers and properties that cannot be financed by traditional means and require mezzanine or hard-money bridges

The dichotomy between these two commercial real estate markets is startling, despite the downside pressure that recently has been seen on bridge and mezzanine loans.

Although this environment has been confusing and often frustrating for commercial mortgage originators (especially for those who are not focused on multifamily), a new wave of sentiment has crept into the market. That sentiment is driven by the “post-QE question.” As the job market continues to show signs of recovery and the Fed pulls back its support, how will the commercial mortgage market react?

Background

To answer this question, it is important to look at how QE works and the role it has played as an unconventional monetary policy in stimulating the national economy since the financial crisis.

Generally speaking, when central banks use QE as an economy stimulus, they purchase financial assets with longer maturities than the short-term government bonds that they typically purchase. As a result, they help lower short-term interest rates. In this most recent recession, with short-term interest rates near zero and unemployment still considerably higher than the Fed’s stated target, the Fed began to purchase assets with these longer dated maturities, thus driving up prices of those assets, and as a result lowering interest rates further out on the yield curve, making borrowing more affordable for businesses and consumers.

Since the onset of the credit crisis, the Fed has engaged in three rounds of QE. Before the recession, the Fed held between $700 billion and $800 billion in treasury notes on its balance sheet, but in late November 2008, it started buying $600 billion in mortgage-backed securities (MBS). By March 2009, it held $1.75 trillion of bank debt, MBS and treasury notes. It reached a peak of $2.1 trillion in June 2010.

In November 2010, the Fed announced QE2, buying another $600 billion in treasury securities by the end of second-quarter 2011. This past September, QE3 was announced when the Fed decided to launch a new $40 billion a month, open-ended, bond purchasing program of agency MBS. Additionally, the Federal Open Market Committee (FOMC) announced that it would likely maintain the federal funds rate near zero “at least through 2015.” This past December, the FOMC announced that it had increased the amount of open-ended purchases from $40 billion to $85 billion per month.

"New U.S. CMBS issuances through mid-April 2013 totaled $30.3 billion, a 284 percent increase."

Many fear that when the Fed stops buying — and begins to sell — long-term securities, and thus signals the end of QE, interest rates could increase dramatically. In fact, this past June interest rates spiked immediately after remarks from Federal Reserve Chairman Ben Bernanke indicated that the Fed could begin reeling in its bond purchasing later this year.

Life after QE

Despite a declining interest-rate environment for much of the past four years, there was little momentum in non-agency commercial mortgage-backed securities (CMBS) refinance or acquisition loans until this past first quarter. Previously, CMBS lenders focused exclusively on institutional sponsors in Tier-1 metropolitan statistical areas and fully stabilized multi-use property types. Changes began to appear by mid-2012, however.

New U.S. CMBS issuances through mid-April 2013 totaled $30.3 billion, a 284 percent increase compared to the $7.9 billion issued in the same period in 2012. The search for yield forced CMBS investors to expand their “credit box” and has led to the resurgence of non-agency CMBS and some loosening in the bank markets. The newly “in vogue” non-agency assets do come with their own limitations, however, including geographic preferences and loan sizes. As certain new collateral types get invited to the financing party, these new issuances also have experienced downward yield pressure and further spread consolidation because competition for assets remains strong.

As the greater economy continues to show signs of improvement, commercial mortgage originators are beginning to face the existential questions about life in a post-QE era. Despite a heavily bifurcated market — with tight/low yield “financeable” loans versus those “outside the party” — questions remain: How will the end of QE affect each market? Is the agency refinance boom over? How will an increasing-rate environment affect an already tight CMBS market? Will other commercial real estate markets open to conventional financing?

By keeping the following points in mind, commercial mortgage originators can adapt to a post-QE environment.

  1. Expect rates to increase further. The prospect of life post-QE will have some serious effects on the bifurcated real estate market. Expect spreads on already tight credits, such as agency and CMBS, to widen as rates start to pick up, which will create a volatile market for borrowers looking to lock in the cost of funds. In addition, expect the secondary market to start taking a short view on rates. The secondary market may start looking for short-duration and average-life products in the near term, which may affect a borrower’s ability to lock in longer dated paper and rate structures.
  2. Beware the cresting refinance wave. When big banks like Wells Fargo & Co. and JPMorgan Chase & Co. announced their respective first-quarter earnings this past April, they indicated that total mortgage banking was down partly because of the diminished refinance activity in agency product. In many ways, this is to be expected and is a sign that markets are functioning properly. Although the sharp drop in mortgage rates in the past few years spurred refinance activity, it inevitably will slow as more borrowers lock in at lower yields. Not only will this phenomenon affect hot markets like multifamily housing, but it also may prove to be an opportunity for other less popular collateral, like retail properties and other small-balance commercial property types.
  3. Move from concentrated to diversified. With previously “in vogue” classes undergoing changes in the post-QE environment, commercial mortgage originators should watch the market closely to see what new opportunities open up in other property types. It is important to stay diversified in this uncertain environment. Pay attention to opportunities in sub-markets like: recovering geographic markets (Tier-2 and Tier-3 metropolitan areas), particularly in the Southwest and Southeast; recovering collateral types such as retail and special-use property loans; and recovering asset classes such as small-balance commercial and new construction.
  4. Get defensive. Commercial mortgage brokers who have been focused on already hot markets may be faced with much uncertainty in the post-QE era. With the prospect of increasing rates and widening spreads, it is important to get defensive. With an already tight CMBS market, expect rate and spread moves to affect borrowers’ cost of funds throughout the loan-origination process and be prepared for re-pricing from lenders and potential re-trades. It is important for originators to keep borrowers aware of this volatility, and try to advocate for defensive loan structures. Push the envelope on behalf of your borrowers to go out longer in rate and term. Inquire about periodic and lifetime rate caps if your borrower only can secure a floating-rate loan structure. Look for opportunities to swap out floating-rate loans for fixed rate, even if it is outside the deal.

• • •

Commercial mortgage brokers who keep themselves apprised of the market changes and capitalize on the opportunities that emerge with these changes can position themselves for success. With this knowledge, they can make the post-QE ride successful — without taking the thrill out of it.    


 


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