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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   November 2013

Looking Beyond Today’s Rates

Set strategies for tackling future interest-rate increases

In the past few months, commercial mortgage brokers, along with other real estate professionals, have kept a close watch on interest rates, bracing themselves for the impact of any increase on their clients’ deals. Although the rate increases thus far have been mild, mortgage brokers and real estate owners should find strategies that give them the most rate protection, but that are still cost effective.

As brokers and their clients consider these strategies, it is important to keep in mind that the near-to-intermediate increase in interest rates will happen on the longer end of the yield curve. Short-term interest rates are being held low. This causes a steepening of the yield curve, which makes longer-term rates less attractive than shorter-term rates.

Changing rates

In the past few years, the Federal Reserve’s bond-buying policy has kept long-term rates (10 years and longer) low. Borrowers have been coming to the funding table trying to lock in the low rates for the longest period possible. Although the Fed recently pushed any tapering of its quantitative-easing policy down the road, rates eventually will start to tick up. In the near term, borrowers should begin to move down the yield curve to shorter-term rates because they are still at historic lows and offer substantial cost savings.c_2013-11_clopton_chart

Commercial short-term variable rates typically are quoted as a spread over Libor (the interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market.) At the time of writing, the three-month Libor rate was about 0.26 percent. An average credit spread would be about 300 basis points, which would result in a rate of about 3.26 percent. Because Libor predominately moves with the rate of federal funds, look at that rate for guidance in movement of the Libor rate. Based on the Fed’s current policy, the federal funds rate isn’t expected to increase until mid-year 2015, and then only if unemployment has dropped to levels near 6.5 percent.

With that in mind, consider two scenarios for a five-year $1 million loan. The first scenario is for the loan taken on an interest-only basis and with a hypothetical variable rate. The second scenario is for the loan taken on a fixed rate. The scenarios are for a five-year term for simplicity and the ability to predict the Fed policy in the near term. Today’s average rate for five-year fixed-rate loans is about 5 percent across commercial mortgage-backed securities (CMBS), life companies, banks and credit unions.

In these two scenarios, the term begins in first-quarter 2014. In the variable-rate loan scenario, assume there will be a rate hike of 25 basis points every two quarters starting in third-quarter 2015. With this hypothetical rate change, the total interest paid at the end of the five years would be $792,000 compared with $950,000 if the loan is taken at a fixed rate, resulting in a $158,000 savings.

The average rate paid on the variable rate loan would be 3.96 percent, while the rate paid on the fixed-rate loan would be 4.75 percent.

Risks

In pursuing a variable-rate strategy, the risks lie in extreme rate hikes.  Because there is no rate protection in this scenario for being tied to Libor, should the Fed deem it necessary to increase the federal funds rates significantly, your clients could see a net loss with this strategy. Should the Fed deem it necessary to keep short-term rates low to continue to help the economy, your clients with variable-rate loans would see significant savings over a fixed-rate loan.

In the foreseeable commercial lending future, interest rates are expected to remain volatile and uncertain. In addition, the current macroeconomic forces hardly have historical references to get guidance over the direction of interest rates, especially with these forces changing all the time.

Showing clients how to manage interest-rate risk, and where and when to get exposed to the yield curve will be imperative for commercial mortgage brokers in the current environment. That is why brokers should educate themselves on interest-rate policies and keep an eye on the markets daily.

Brokers also should be aware that interest-rate volatility will affect their ability to execute loans properly, especially if their clients already have tight debt-service ratios. CMBS lending especially can be frustrating in a volatile interest-rate environment, as the rate of the loan will change frequently until you are within arm’s reach of closing.

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In today’s market, borrowers appreciate working with brokers who can provide insights about the impact of interest rates on their deals. In the coming months and years, staying current on the Treasury and swap markets, as well as understanding the economic policies affecting rates, will separate the successful brokers from the rest. 



 


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