Western Real Estate Business

JUN 2018

Western Real Estate Business magazine covers the multifamily, retail, office, healthcare, industrial and hospitality sectors in the Western United States.

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www.REBusinessOnline.com Western Real Estate Business • June 2018 • 41 Despite ample capital available for well-conceived projects in both primary and secondary markets, short-term borrowing costs are rising as the Federal Reserve pur- sues its gradual rate-tightening program. Yet some commercial real estate borrowers are finding a silver lining in the flattening yield curve, or the narrowing spread between short- and long-term lending benchmarks. This unusu- ally flat yield curve has created a hedge opportunity for floating-rate borrowers concerned about rising interest rates. The two-year Treasury yield hit 2.547 percent on May 14, its highest point in nearly a decade. Recent increases in the 10-year Treasury have been relative- ly slight, however. That yield stood at 3.002 percent on May 14, a difference of less than 46 basis points. The relatively flat yield curve presents an excel- lent opportunity for commercial real estate bor- rowers to refinance into longer-term debt. This is particularly appealing to floating-rate borrowers concerned about further rate hikes by the Fed. To understand why, we must consider how the lending environment has evolved. Straightening the Curve In normal conditions, an upward-sloping yield curve reflects a premium or additional yield to com- pensate long-term investors for incurring the added risk of holding a bond for a longer term. During the normal curve observable during the past 10 years or so, the spread premium was roughly 150 to 200 basis points. The Treasury curve began flattening after the spike in Treasury yields that occurred days after the 2016 presidential election. Since then, the spread between the 10-year and two-year Treasurys has contracted significantly. It got as narrow as 41 basis points on April 17, and is currently around 48 basis points. For context, the spread hasn't been this tight since the summer of 2007, several months after the yield curve inverted (to pay higher annual yields on short-term bonds than on long-term bonds). Because Treasury yields are a common bench- mark for commercial real estate lending, the spread in recent years made interest rates for short-term commercial mortgage debt more attractive than lon- ger-term debt. For example, strong applicants with cash-flowing properties could borrow floating-rate, non-recourse senior debt at about 2.75 percent (the 30-day LIBOR rate plus 250 basis points) four years ago. Alternatively, they could lock in 10-year, non- recourse senior debt costing about 100 basis points more at 3.75 percent (10-year Treasury rate plus 175 basis points). LIBOR is a popular benchmark for set- ting short-term and floating lending rates. Savvy long-term investors recognized the savings potential of this 100-basis-point delta and borrowed short-term debt, with the intent of refinancing into longer-term debt later if they anticipated rates were going to rise. Given that the Federal Reserve began hiking rates in earnest last year, these investors did very well utilizing this arbitrage strategy. Floating-rate borrowers are now using the flat- ter yield curve as a hedge against further Fed rate hikes. Given that the spread between the 10-year and two-year Treasurys is roughly 50 basis points, pricing for new, long-term, fixed-rate debt may be similar to the floating rates borrowers are currently paying. For example, a floating-rate loan originated two years ago with an initial interest rate of 3 percent would reflect a coupon of 4.4 percent today. Life companies, a popular source of long-term debt for commercial real estate, can presently offer mort- gage rates between 4 percent and 4.5 percent, with loans earmarked for CMBS priced slightly higher, between 4.5 percent and 5 percent. If short-term rates were frozen at today's levels, a borrower with a five-plus-year investment horizon might be indif- ferent to fixed- or floating-rate debt. The market outlook, however, provides another reason to convert short-term debt to long-term, and adds a degree of urgency. As the forward curve shows, the market is pric- ing 30-day LIBOR to increase to 2.6 percent by May 2019, and to 2.8 percent in 2020. Those numbers suggest a 60-basis-point increase to floating rates over the next 12 months. When you apply that to our example, the loan originated in 2016 at 3 percent interest could spike to more than 5 percent by next summer. This alone is a persuasive argument to sway long-term investors into refinancing floating- rate debt with fixed-rate debt. Interest rate caps could mitigate some increasing rate risk, but they are getting expensive due to the recent Fed rate hikes. More importantly, caps don't provide protection from a potentially higher-rate environment when the loan matures within the next few years. The real estate community has benefited from his- torically low interest rates during this expansion cy- cle. Smart investors have leveraged the yield curve over the past few years to maximize returns. Now that we have entered the higher-rate envi- ronment we'd hoped to avoid, investors can lever- age the yield curve for defensive positions. This temporary flatness allows floating-rate borrowers to take rising interest rate risk off the table by refi- nancing into long-term, fixed debt at a potentially nominal expense. n The Curious Incident of the 10-Year Treasury Bond experts are unclear why the 10-year Treasury has not climbed in conjunction with the lift seen in the two-year Treasury. Many feel it should be exhibiting a higher yield given current macroeconomic conditions, includ- ing Fed balance sheet normalization and con- tinued deficit spending like recent tax reform measures, Eurozone recovery and other condi- tions. It should be noted, however, that the 10- year Treasury yield momentarily breached 3 percent in April and again in May. This could mean we will see that upward trajectory soon. Therefore, it is not far-fetched to imagine long- term, fixed senior debt interest rates around 5.5 percent. This was where commercial real estate lending rates stood before the 2008 financial crisis. With this in mind, existing long-term rates could be considered a bargain. 10-YEAR MINUS TWO-YEAR TREASURY CONSTANT MATURITY 0 1.0% 2.0% 3.0% 0.5% 2014 1.5% 2.5% Source: Federal Reserve Bank of St. Louis 2015 2016 2017 2018 Murphy THE YIELD CURVE'S SILVER LINING By Rob Murphy, Vice President of Structured Finance, Transwestern in Los Angeles 0 .0% 1 .0% 2 .0% 3 .0% 4 .0% 5 .0% 2018 2019 2020 LIBOR FORWARD CURVE | 3 YEARS MARKET EXPECTATIONS +1 STANDARD DEVIATION Source: Pensford Financial Group LLC

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