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Monthly Newsletter
Assessing Risk in a Dynamic Interest Rate Environment
August 2024
Key Highlights
Recently, expectations of a lower federal funds rate have begun to dominate discussions among borrowers and lenders.
Borrowers are increasingly focused on timing financing activities to coincide with short-term interest rate movements, which is both difficult to achieve and can pose risks to an otherwise viable financing package.
In an environment like this, sound guidance revolves around the notion that a borrower’s primary objective is to use financing as a tool to successfully execute a business plan.
Expectations of a Lower Interest Rate Environment are Driving Decision Making
Once again, much discussion in the commercial real estate industry has focused on Fed actions and interest rate expectations through the remainder of the year and into 2025. Market participants have coalesced around the belief that monetary policy actions will soon result in an interest rate decrease(s).
As discussion heats up on the topic of rate cuts, borrowers are becoming more focused on short-term interest rate movements, and this is leading to a more intense focus on loan pricing. Sentiment among borrowers has shifted in favor of waiting for the arrival of a lower interest rate environment as many seem to believe that a decrease in overall loan costs is imminent. In some corners of the market, this has created a bias against action under the premise that closing on financing today will result in a missed opportunity to obtain the same financing on better terms in the future.
This sentiment fails to incorporate the technical mechanics that underlie floating-rate loan products like construction and bridge debt. It also does not consider potential scenarios that could prevent rates on long-term, fixed-rate debt from decreasing. Borrowers should take the time to understand all potential scenarios that could impact the financing package and weigh the risks associated with each.
As discussion heats up on the topic of rate cuts, borrowers are becoming more focused on short-term interest rate movements, and this is leading to a more intense focus on loan pricing. Sentiment among borrowers has shifted in favor of waiting for the arrival of a lower interest rate environment as many seem to believe that a decrease in overall loan costs is imminent. In some corners of the market, this has created a bias against action under the premise that closing on financing today will result in a missed opportunity to obtain the same financing on better terms in the future.
This sentiment fails to incorporate the technical mechanics that underlie floating-rate loan products like construction and bridge debt. It also does not consider potential scenarios that could prevent rates on long-term, fixed-rate debt from decreasing. Borrowers should take the time to understand all potential scenarios that could impact the financing package and weigh the risks associated with each.
Floating-Rate Loans Automatically Capture Rate Decreases
Amid the ongoing rate discussion, important facts about floating-rate loans – often bridge and construction products – are being overlooked. For example, automatic pay rate adjustments are one of the key features present in most floating-rate debt products. The presence of this feature means that in the event Fed action drives down the underlying index rate, the interest rate used to calculate debt service payments will also decrease.
Floating rate debt can be a strong option when faced with the prospect of declining interest rates, but it is important to understand that some floating rate products have a floor rate that prevents the pay rate from decreasing below a predetermined point. This caps the benefits to the borrower and should always be negotiated. Borrowers should understand the intricacies of the loan product and should consider individual products and features in the context of the asset, business plan, and risk profile.
Floating rate debt can be a strong option when faced with the prospect of declining interest rates, but it is important to understand that some floating rate products have a floor rate that prevents the pay rate from decreasing below a predetermined point. This caps the benefits to the borrower and should always be negotiated. Borrowers should understand the intricacies of the loan product and should consider individual products and features in the context of the asset, business plan, and risk profile.
Borrowers Expecting Lower Rates on Fixed-Rate Debt Could Be in for Disappointment
One of the underappreciated risks in today’s market lies in delaying long-term financing under the premise that Fed action will drive down the long end of the rate curve over the coming months. The factors that determine long-term interest rate movements go far beyond the Fed’s monetary policy activities. Together, these factors are varied, complex, and very difficult to forecast.
Among the possible scenarios, one is Fed action resulting in lower short-term rates, while having only a minimal impact on the long end of the rate curve. Under this scenario, a decrease in 10-year Treasury yields could be muted and have a limited impact on the cost of long-term, fixed-rate loans.
Borrowers who wait to refinance with the expectation that borrowing costs will come down over the next several months could find themselves in a situation where time passes, the current financing arrangement draws nearer to maturity, and long-term loan costs do not decrease. These borrowers could be forced to rush into a solution or risk exposure to a financing gap.
Among the possible scenarios, one is Fed action resulting in lower short-term rates, while having only a minimal impact on the long end of the rate curve. Under this scenario, a decrease in 10-year Treasury yields could be muted and have a limited impact on the cost of long-term, fixed-rate loans.
Borrowers who wait to refinance with the expectation that borrowing costs will come down over the next several months could find themselves in a situation where time passes, the current financing arrangement draws nearer to maturity, and long-term loan costs do not decrease. These borrowers could be forced to rush into a solution or risk exposure to a financing gap.
The Importance of Loan Pricing and Structure in Gauging Risk
Borrowers who excel at managing risk and achieving strong long-term performance understand that loan pricing is a complex matter because it is governed by two components – an underlying interest rate index and a spread. Both fluctuate continuously and are subject to market forces, short-term economic developments, and human emotion. As such, producing useful, forward-looking projections for these components is extremely difficult to accomplish, especially over the relatively short lifecycle of a financing event.
Borrowers should also be aware that rate lock mechanics vary between loan products and expose borrowers to different levels of risk between the time of application and loan closing. Life companies, for example, typically lock the interest rate at the time of application, so borrowers are not subject to potentially adverse rate movements leading up to closing. On the other hand, borrowers who select a CMBS product are not able to lock the rate until the loan closes and should be aware of the risks this entails.
Borrowers should also be aware that rate lock mechanics vary between loan products and expose borrowers to different levels of risk between the time of application and loan closing. Life companies, for example, typically lock the interest rate at the time of application, so borrowers are not subject to potentially adverse rate movements leading up to closing. On the other hand, borrowers who select a CMBS product are not able to lock the rate until the loan closes and should be aware of the risks this entails.
CMBS Brings Unique and Misunderstood Risks
CMBS has seen a moderate resurgence in recent months as more borrowers seem willing to bet that rates will decrease as the closing date approaches. Many borrowers don’t realize that this bet involves three factors, all of which can work independently in favor or in opposition of the borrower’s objectives.
First, every loan index is influenced by Treasury rates, which can become volatile due to economic, political, or other events. As a result, index benchmarks can fluctuate in unpredictable ways, and given the absence of a pre-funding rate lock, CMBS borrowers are most susceptible to the risks this entails.
Second, spreads play a significant role in loan pricing. Borrowers should understand that widening spreads can counteract a decrease in the index rate and may produce a higher overall borrowing cost. Index and spreads have been known to move against borrowers in the period leading up to the rate lock date to an extent that a previously viable deal no longer pencils.
Finally, borrowers often attempt to size an upcoming loan to match the exact amount needed to fill the capital stack. If movements in the index rate and the spread combine to work against the borrower, they may be forced to accept a lower loan amount on short notice. This can suddenly leave the borrower with a gap in the capital stack, which can upend an otherwise sound deal.
First, every loan index is influenced by Treasury rates, which can become volatile due to economic, political, or other events. As a result, index benchmarks can fluctuate in unpredictable ways, and given the absence of a pre-funding rate lock, CMBS borrowers are most susceptible to the risks this entails.
Second, spreads play a significant role in loan pricing. Borrowers should understand that widening spreads can counteract a decrease in the index rate and may produce a higher overall borrowing cost. Index and spreads have been known to move against borrowers in the period leading up to the rate lock date to an extent that a previously viable deal no longer pencils.
Finally, borrowers often attempt to size an upcoming loan to match the exact amount needed to fill the capital stack. If movements in the index rate and the spread combine to work against the borrower, they may be forced to accept a lower loan amount on short notice. This can suddenly leave the borrower with a gap in the capital stack, which can upend an otherwise sound deal.
Prioritizing Objectives Can Help Borrowers Think Clearly About the Timing of a Financing Event
During periods of heightened interest rate discussion, borrowers should remind themselves of their primary responsibility, which is to manage the project or asset with the goal of maximizing risk-adjusted returns on invested capital. This is typically achieved by focusing on intelligent underwriting, excellent business plan execution, and meticulous asset management. Most successful owners understand that fluctuations in rates are unlikely to be the deciding factor in the long-term performance of the asset.
On the other hand, those who expend resources to achieve perfect timing and pricing on a financing event often find that those resources could have been deployed more effectively into other endeavors. Many capital experts rightfully point out that borrowers with a myopic focus on obtaining the absolute lowest pricing are significantly more likely to bring undue delays and risks to the deal.
On the other hand, those who expend resources to achieve perfect timing and pricing on a financing event often find that those resources could have been deployed more effectively into other endeavors. Many capital experts rightfully point out that borrowers with a myopic focus on obtaining the absolute lowest pricing are significantly more likely to bring undue delays and risks to the deal.
Final Thoughts
The primary responsibility of a capital expert is to place their clients’ interests first and to serve as an advisor across market cycles. In today’s market, this role entails helping clients understand the interest rate risks that are present but not always easy to detect. It also includes looking out for borrowers’ long-term interests by reminding them that short-term rate fluctuation should not cloud the primary goals of a commercial real estate operator, specifically executing on a business plan, financing a sound project, and building a strong portfolio. Financing should always be selected and structured with these primary goals in mind.
Talonvest Capital specializes in structuring and negotiating comprehensive capital solutions for owners of industrial, self-storage, multifamily, office, and retail assets. We create tailored capital solutions for our clients by sourcing cutting-edge lending programs and advising on capital markets trends.
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