Despite a rising interest rate environment, commercial real estate pros are still finding opportunities to do deals, albeit with a more cautious tone, according to panelists at Real Estate Finance & Investment’s breakfast briefing on Tuesday.
“For a long time, we advised clients for to spend as little money as they could on rate protection and just enjoy paying almost nothing for debt,” said Christina Ochs, president and CEO of the Corporation for Interest Rate Management, an advisory firm. “We are now encouraging clients to hedge sooner and more aggressively, as their [36-48 month] floaters are easily 50 to 80 basis points above where they were budgeting at the end of 2017.”
As the 10-year Treasury has inched up closer to 3%, moderator Scott Singer, president of the Singer & Bassuk Organization, asked the crowd how many people expected Treasuries to be higher at the end of this year than they are now. Almost every hand in the room shot up.
But Singer noted that a flattening yield curve could confuse that seemingly simple question. “Which Treasury rate am I talking about?” he asked. “The delta between the 10-year and the 30-year rate is 17 basis points, while the delta between the two-year and the 10-year is 65 basis points. The 10-year is higher than the 30-year was.”
Owners are feeling the effects of rising rates both on their own finances and those of their tenants. “Over the past few years, we went out and refinanced all of our properties at favorable terms with several years of IOs, so we have a few years ahead of us before we have to deal with that,” said Scott Galin, CEO and principal of Handler Real Estate Organization. “But from a leasing standpoint, there is no doubt that our tenants feel better about business and therefore, we’re going to be able to see solid rent numbers, so when we do have to refinance, we shouldn’t have coverage ratio issues because the buildings will have even stronger metrics.”
But timing a rate increase can be difficult, even when you can feel the headwinds, according to Galin. “We knew it was coming, but we were not perfect regarding timing; we thought it was going to be at least a year earlier.”
The panel also addressed whether prepaying a loan now, in the face of a flattening yield curve, was a smart move. “The flattening of the yield curve means that long-term rates haven’t changed that much and I think that’s an ideal time to prepay,” Singer said.
But the actual feasibility of a loan prepayment depends on a variety of factors, including the actual cost of the prepayment penalty, the borrower’s projection of how high interest rates will rise, and if spread compression is happening in that part of the lending market. “Even if it’s a hefty prepayment penalty, things are only going to get worse. So, should we bite the bullet now and lock it in over the long run?” Jeff Simpson, managing partner at Arch Companies, asked.
He noted that for operators trying to implement a value-add capital improvement plan, it could be worthwhile to wait until the cash flows are stable enough to pay off the existing loan with the prepayment penalty. That assumes the value of both the property and the loan will be higher after the value-add program has been implemented.
Conduit spreads have also started to vary widely among issuers in the last six weeks, according to Singer. “When we go out to market with a deal, there’s often a 75 basis-point differential within the CMBS quotes we’re receiving. The reality is that there’s a lot of arbitrage in the market and a different lender needs a certain type of property the most on any given day.”
Fear is also playing a role in making sure that deals continue to get done. “In nearly every transaction I see, [the seller] wants to close as fast as possible due to fear that rates will go up,” said Doug Larson, executive v.p. of valuation and advisory for Newmark Knight Frank. “This common mindset has forced banks to react quicker and exercise more due diligence at a faster pace—and I think this trend is going to stay.”
Simpson agreed. “At a conference I was at recently [for operators], I kept hearing words like, ‘We’ll keep dancing as long as the music’s playing.’ That generally means that people are scared that the music is going to stop.”
By: Sondra Campanelli, REFI US