Time heals all. As much as things change, they remain the same. Interest rates are going up (or down). History repeats itself. These are some of the typical business cliches that get tossed about. And yes, each are true. Everyone wonders where interest rates are going and how to prepare for the fluctuations that are sure to come. History does repeat itself.
The one-year London Interbank Offered Rate (LIBOR), which is the rate of interest at which banks offer to lend money to each other, was a mere 0.26% in May 2021. A year later, the rate was 10 times higher at 2.68%. Think about telling your clients that the interest rate on their loan is 1,000% higher than a year ago.
From mid-April to mid-May of this year, the one-year LIBOR rate increased by 13 basis points. For those who feel that LIBOR is not a good indicator and prefer the federal funds rate, note that this metric doubled between the weeks of April 18 to May 16 of this year. There are warning signs that the market is headed for a major rate spike over the next few years.
If you feel U.S. Treasurys are a better economic indicator, then note that one-year Treasury rates have had a relatively steady rise from 0.38% on Jan. 4 to a high of 2.11% on May 19. These rates were much more stable over the course of 2021, which saw a total swing of only 35 basis points.
Remember that loans need to close, whether rates are high or low. This holds true for bankers, brokers and borrowers.
These three indicators — LIBOR, the federal funds rate and the Treasury rate — are now telling commercial real estate investors that it’s either time to lock in financing or be prepared for substantially higher rates as the year moves forward. “It is of paramount importance to get inflation down,” Federal Reserve Board Gov. Lael Brainard said during a speech this past April.
Brainard explained that the Federal Open Market Committee, which sets interest rates, “will continue tightening monetary policy methodically through a series of interest rate increases and by starting to reduce the balance sheet at a rapid pace.” This more aggressive Fed chatter comes as the 30-year fixed mortgage rate has topped 5%, a key threshold that is likely to slow the housing market.
The Fed is attempting to be responsive to the ever-mounting pressure points. The annual inflation rate in March 2022 reached 8.5%, with the overall cost of such staples as food and gasoline growing at the fastest pace in decades while the gap between labor supply and demand is the widest it’s been since the end of World War II. If one adds in the tragedy of the Russia-Ukraine conflict and the uncertainty of commodity supply chains, the reality of continued inflation and eventual recession begins to loom large.
Typically, upward movement in interest rates will result in a decline in housing starts and a directly related decline in the sales of raw building materials. Left unchecked, this will result in greater unemployment as inflation and costs of goods increase, thus forcing interest rate increases designed to support an economy that faces declines in many sectors.
While the federal funds rate does not directly impact mortgage rates — which depend largely on the 10-year Treasury bond yield — they often move in tandem for similar reasons. With the 10-year Treasury yield zooming higher in recent months as the market anticipates Fed rate hikes, mortgage rates have risen as well. The costs of construction financing and bridge financing for real estate acquisitions have jumped along with the balance of the financial markets.
There should be little doubt that mortgage rates have kissed goodbye to their record lows. They have soared higher in the past several months in response to inflation and the perceived steps that the Fed will need to take as a result.
If you combine all of these facts with the pandemic-related supply chain issues for everything from computer chips to automobiles to lumber, it seems reasonable to infer that inflation and the cost of living is rising. Will this lead to a major recession? Maybe. After all, history does repeat itself and many indicators point to the U.S. being on the path to recession.
It has been predicted that home loan rates will remain elevated and possibly stay above 5% by year’s end. This will most certainly slow housing starts as well as dampen any expansion to the economy, perhaps as a precursor to the recession predicted by many economists. As of this past May, 30-year rates were at their highest levels since 2000.
Numerous experts now forecast that a recession for the U.S. is practically a sure thing. In a recent interview with Bloomberg, former Treasury Secretary Larry Summers stated that “there has never been a moment when inflation was above 4% and unemployment was below 5% when we didn’t have a recession within the next two years.”
Summers criticized the Fed for suggesting that a “soft landing” is likely, advising its leaders to level with the public by issuing a far more realistic and rocky view for the road ahead. Earlier in the year, Bill Dudley (the head of the New York Fed from 2009 to 2018) gave an even more gloomy assessment in a Bloomberg opinion piece titled, “The Fed has made a U.S. recession inevitable.”
Dudley wrote that the central bank was wrong in keeping monetary policy so loose for so long because “cooling things off” will require a tightening so severe that it’s bound to send the economy from boom to bust. Many current indicators back up his assertions.
Keep it simple
What does all of this mean for the commercial mortgage industry? In these difficult times, one needs to be realistic to discern where best to make deals. Remember that loans need to close, whether rates are high or low. This holds true for bankers, brokers and borrowers.
The big question is, how do you get a new deal closed and what is a logical rate? The simplest plan for closing a loan is typically the best. The first rule for brokers and borrowers is to assume your lender is knowledgeable and wants to make loans. After all, banks and nonbanks alike are in business to disperse capital in difficult rate environments as well as low-rate times.
Present your client’s loan request with clear and concise information. Prepare an honest summarization with all the required facts. Now is not the time to overpromise. It is a time to be realistic with your clients and tell them that the rate environment is volatile at best. If they want their loan to close, they need to consider realistic rate assumptions, knowing that in a year or two, the market will likely turn.
Try to negotiate for no prepayment penalties in the hope that when the market turns, you’ll be able to lower the borrower’s current interest rate. You should be successful with these simple guidelines. Once again, history does repeat itself and when rates go up, they eventually come back down.
Bankers and brokers alike need to remember that the very first rule of a transaction is full and complete disclosure. Be clear about personal guarantees and the reality of collateral.
Understand that debt service coverage is needed no matter the interest rate, so project scenarios with realistic numbers. Understand that historical operating numbers are the basis for debt-service-coverage ratios, while projections are the dreams that developers sell to equity investors, not the reality upon which a lender relies.
In time, the client’s deal will close and a few extra percentage points in interest will provide them with the opportunity to realize profits from their equity investment. Remember that a rate swing of 2 percentage points on a $10 million loan equates to roughly $200,000 per year or more than $16,000 in monthly cash flow. Over time, however, the mortgage rate will become insignificant compared to the cash-flow profit provided by the asset.
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Given average loan-to-cost ratios, the total investment on the hypothetical project above would be about $15 million. This makes the reality of $200,000 in annual cash flow to service the debt a small matter when compared to the alternative of not completing the project.
Realism is the watchword. Make your presentation real with logical financial information and your banker will become your partner. Remember that each of you has the same goal — to close the loan. ●
Jerry Sager is senior managing director of First National, a leading principal lender to the hospitality industry, mixed-use commercial properties, golf courses and special-asset owners. With more than 25 years of experience in lending to property owners and management companies, his team has provided financing for the acquisition, construction, expansion and refinancing of specialized assets throughout the U.S.
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