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The good news is that Covid-19 seems to be waning and life is returning toward normal. The bad news: raging inflation – no longer thought to be “transitory” – is taking an extreme toll on consumers and the economy at large. Inflation, exacerbated by the war in Ukraine that has had severe effects on the energy and agriculture markets, has pushed the Federal Reserve to begin raising the Fed Funds rate and halt their Quantitative Easing.
Most experts expect them to continue raising the Fed Funds rate to at least 3%, with some even suggesting they need to continue raising until interest rates are higher than inflation. Many of these same experts are also expecting the Fed’s action to lead to a recession in 2023 or 2024.
More specifically, the global financial, economic, and geopolitical environment has played havoc with real estate financing markets in 2022. This is exemplified by the yield of 5-year treasury bonds moving from 1.27% at the end of 2021 to nearly 3.0% recently before backing off to about 2.75%; 10-year yields have moved almost as much to a level more or less equal to 5-year yields. The implications for the real estate financing markets have been significant:
- Lenders have been chasing the bond market, raising their loan interest rates, but trying not to raise too much such they become uncompetitive. As such, it is a rapidly changing market with slow lender responses and wide variations between lenders in many cases;
- While borrowers could have obtained interest rates at high leverage in the low 3% range early in the year, now they can be lucky to get a mid 4% interest rate. Fully-leveraged Fannie Mae or Freddie Mac loans can now be over 5%;
- Perhaps more seriously, the higher interest rates are also resulting in substantially lower leverage. Debt yields and underwriting interest rates for DSCR calculations are being raised, which cuts back on loan amounts for both fixed and floating-rate loans (including bridge loans);
- Some bridge loan lenders that typically provide floating-rate loans are now providing fixed-rate bridge loans, thus eliminating the need for buying ever-more-expensive interest rate caps while also eliminating the risk of rising debt service; and
- The reduced leverage and higher interest rates are causing pressure on valuations. Buyers that agreed to prices early in 2022 – with lower interest rates - have been pushing for price or other concessions from sellers in order to make their deals still work with higher interest rates. While these lower prices have likely not shown up in appraisals yet, they are likely to later in the year once more such deals are closed.
As such, our recommendations for prospective borrowers include:
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If you need financing, don’t wait. We don’t know how far these interest rates will rise, but we see the potential for lots of downside (ie higher rates) with little potential upside for the remainder of 2022 given that the Fed moves are just beginning and geopolitics appear to be shifting toward more conflict rather than less.
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Refinance out of floating interest rates. Interest rates on existing floating-rate loans will almost certainly be moving substantially higher. Although interest rates on fixed-rate loans are now substantially higher than they were, they can still be attractive relative to a relentlessly-rising floating rate;
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Take advantage of the flat yield curve. With the yield curve very flat, it may be advantageous to take the longest loan term available that still fits the business plan; and
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Prepayment flexibility is valuable: refinance to a fixed rate now to limit the risk of rising debt service while retaining the flexibility to affordably refinance in the next few years if the environment improves.
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