The Treasury bond markets are mysterious for many commercial real estate investors. Their relevance and connection to dealmaking and available financing options may not be readily apparent.
Fortunately, there is a valuable tool at everyone’s disposal: the Treasury yield curve. Grasping the yield curve, however, can take a bit of study and reflection. More than simply understanding a conceptual tool, mortgage brokers and borrowers need to know how bond markets and monetary policy will affect the performance of real estate portfolios so that they can respond appropriately.
There are certain economic conditions that can lead to a flat or inverted yield curve. This has implications for commercial real estate stakeholders. Finance professionals and their clients with knowledge in this area can cope — and thrive — despite market volatility and rising interest rates.
Before digging into the shape of the yield curve, you’ll first need to understand what it is. The yield curve is a benchmark for debt in the market. It is represented by a chart that illustrates the difference in the yields, or rates of return, between short-term and long-term Treasury bonds. The maturity periods for these bonds typically span three months to 30 years.
The curve helps investors see the market interpretations of future economic performance. Higher interest rates imply greater economic performance, which can lead to rising inflation. When the curve slopes upward, short-term yields are less than long-term yields, and investors project economic growth. Investors generally perceive this as normal since long-term bonds carry greater economic risk (such as the likelihood of rates changing significantly) than short-term bonds.
When the curve is flat, short-term yields are roughly the same as long-term yields, indicating that interest rates are projected to hold steady. And when the curve is inverted, short-term yields are higher than long-term yields, so investors will anticipate declining interest rates that are often associated with an economic recession.
When the yield curve flattens or inverts, it is crucial for mortgage brokers and other finance professionals to act as the borrower’s guide, assisting them in securing a loan that will minimize their financing costs and economic risk.
Another economic indicator for investors is the yield spread between different maturities. The 10-year yield minus the two-year yield is a commonly referenced indicator. A positive value indicates a positive slope to the yield curve (normal) while a negative value indicates an inverted curve. The greater the pitch, the more significant the difference between short- and long-term bond yields. Values that are marginally positive or negative indicate a relatively flat curve.
An inverted yield curve has preceded the past seven U.S. recessions dating to the early 1970s, and inversion is typically followed by a recession within two years. There have been regular, periodic inversions over the past 50 years and the most significant occurred in March 1980 when the yield curve reached a negative spread of 3.16%.
The last time there was a significant domestic downturn, the yield curve inverted in 2006 and bottomed out at negative 0.48%, signaling the oncoming Great Recession. The market topped out and the economic decline followed the inversion in mid-2008.
There have been a couple minor inversions in the past few years, 2022 included. The spread between the 10-year and two-year Treasury dipped slightly into negative territory in August 2019 — a flat or marginally inverted curve — before rising and topping out at 1.59% in March 2021. A flattening trend followed this peak before the spread bottomed out again early this past April at negative 0.05% (a slight inversion).
A flattening yield curve, which the market experienced this past spring, typically accompanies market volatility. When the Treasury markets swing, investors become much more conservative in anticipation of rising Federal Reserve benchmark rates (i.e., the cost of capital). Additionally, banks tend to tighten underwriting guidelines when the curve flattens, resulting in the origination of fewer loans.
Currently, there is still substantial availability of debt and equity due to a large amount of liquidity in the market. But debt is becoming more expensive for borrowers as evidenced by the 50 basis-point rate increase by the Fed this past May. Rates are likely to continue on an upward trend. Yet rising rents, cash flows and valuations in this inflationary environment help to mitigate rising interest rates and compress capitalization rates in some asset classes, although others are not as fortunate.
Even though an inversion often signals a pullback in the economy, it doesn’t always put a damper on the appreciation of commercial real estate asset values. In 1979, for example, as the curve started its dramatic inversion that segued into a pair of recessions in the 1980s, a period of record-high inflation occurred when the rate hit 13.3% year over year with an accompanying Fed funds rate of 12%.
Following this inflation peak and subsequent trough in the yield spread, the NCREIF Property Index (NPI) rose more than 5% year over year, easily surpassing its prior average of 2%. Similarly, NPI appreciation remained positive after the curve inverted in 2000.
Responding to change
When the yield curve flattens or inverts, it is crucial for mortgage brokers and other finance professionals to act as the borrower’s guide, assisting them in securing a loan that will minimize their financing costs and economic risk. As a result of market volatility and rising rates, there is currently a significant transition from floating-rate to fixed-rate debt instruments in order to offset economic risk. Interest-only loans are another avenue for borrowers to keep their debt service to a manageable level.
Additionally, it’s a good time for real estate owners to evaluate opportunities to raise rents or cut noncritical expenses to increase cash flow. When borrowers conduct due diligence on potential acquisitions or refinances, advise them to be conservative in pricing assumptions on all fronts — purchase amounts, interest rates and cap rates — as it’s difficult to predict how the Fed and the market at large will respond to evolving conditions.
To temper assumptions regarding the direction of the market when looking at the yield curve, stress testing is an appropriate measure to visualize the outcomes the borrower may experience in various economic scenarios. In this instance, it’s prudent to build financial models that allow the borrower to plug in the most likely and the most extreme values for each relevant variable.
And there’s an opportunity to leverage data-management technology to aid borrowers in the collection and analysis of data across their portfolios so they can assess the performance of each asset. With the insight that analysis provides, borrowers can determine if prevailing market conditions present viable opportunities to reduce debt expenses, minimize economic risk, bump up rents and valuations, or exit and seek higher-performing assets.
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In a volatile market that can move 15 or 20 basis points a day, borrowers need to be in constant contact with their broker to understand all the available financing options. They also should receive multiple quotes from all types of lenders as the best loan for their assets can change on a daily basis. No matter the option they choose, it needs to be a loan that makes the most sense for their asset, as the curve does not respond in a uniform manner. ●