What's behind your Rate?

Whether you're a local developer or an international real estate investor, interest rates have an enormous impact on your deals. Interest rates help determine how much you can borrow, and they have an enormous impact on a project's overall profitability - the primary concern in your investment decision.

It's easy to understand how interest rates impact profitability, but what isn't necessarily as clear is what influences the interest rates themselves. Commercial real estate transactions don't happen quickly, and being reactive to rate changes is a bad way to do business. By understanding the factors that push CRE interest rates up or down, you can stay ahead of the game, making decisions strategically, rather than reactively.

So, what are CRE rates based off of, and what causes them to move?

The Benchmark Rates Underlying CRE Investment

Unlike residential home rates, which are based on mortgage-backed securities traded on the market as bonds, CRE rates are based on a number of different benchmarks, depending on the type of project. When you go into a bank for financing, these benchmark rates represent the starting point from which the bank will determine how much interest to charge you. The additional rate, or Spread, on top of the benchmark will reflect the relative perceived risk in the loan. Each loan gets assessed individually on its own merits and risks, there is not a set Spread rate for all loans.

Construction rates tend to be based on short-term benchmarks like Prime or LIBOR. The Prime rate is the rate U.S. banks charge to preferred borrowers, and it's usually set 3% above the Federal Reserve's Federal Funds Rate. LIBOR is a European rate based off an average of the rates at which banks lend to each other on the London inter-bank market. For investment property being held over the medium-term and long-term, rates tend to be based on either five or ten-year Treasury Note yields. For multifamily properties, the benchmark is typically the Federal Home Loan Bank rate or one of the GSE Bond Rates. GSE stands for Government Sponsored Enterprise, and two of the largest multifamily lenders in the U.S. are GSE lenders, namely Fannie Mae and Freddie Mac.

The Primary Factors Affecting the Movement of Benchmark Rates

Inflation and the Federal Funds Rate

As mentioned above, the U.S. Prime rate is set based on the Federal Funds Rate. That rate is set by the Federal Open Market Committee (FOMC), who raise it or lower it as needed to keep inflation in check and to maintain healthy, balanced economic growth. Generally speaking, lower interest rates mean more readily available money, which causes the economy to grow and inflation to rise. Likewise, higher interest rates generally restrict economic growth, but also stifle inflation. In 2018, in response to the exceptional performance of the economy, the FOMC raised the rate four times, to its current level of 2.50%. In contrast, from 2008 to 2015, it was lowered to effectively 0.0% to combat the lingering effects of the 2008 financial crisis, a prime example of how the committee's choices are driven entirely by current economic conditions and overall health.

Treasury Note Yields

Bonds - mainly five and, in particular, ten-year treasury notes - are so important to CRE rates that Colliers calls them the "building blocks of commercial real estate." The face value and interest rate, or coupon payment, of a bond, are fixed at the time of issuance. However, the secondary market for bonds is enormous, and prices constantly fluctuate with supply and demand. Bond yields move inversely with bond prices - the higher the price over face value, the lower the yield. Basically, the bond issuer - in this case the United States Government - is only going to pay back the fixed face value and coupon payments, so the more you pay above face value, the lower your return by comparison.

Lenders tie commercial mortgages very closely to these treasury note rates specifically because of how secure they are. Treasury notes are backed by the U.S. Government, which will never default on them unless it defaults on all of its debt obligations - a disastrous scenario that is extremely unlikely to happen. As with any investment, extremely low risk means extremely low reward, and so the interest rates paid by these notes are minimal. But because they're so secure, they essentially represent a risk-free rate of return that lenders can then use as a baseline against which to index their own interest rates.

Since supply and demand determine bond yields on the secondary market, so too do they essentially determine commercial interest rates. When bond prices fall on the secondary market, yields go up. Those higher yields mean that the U.S. Government needs to offer higher interest rates on future bond offerings to attract investors. Those higher interest rates essentially lift up the "floor" on risk used by commercial lenders, who then raise their own rates to closely follow the treasury notes.

What Can We Expect in the Near Future?

The general consensus is that interest rates are going to continue to go up in the near future, and while that certainly is likely, there have been some recent drawbacks in estimates of just how much the increases might be. Throughout the second half of 2018, the Fed projected there could be up to four rate hikes throughout 2019 and 2020, lifting the federal funds rate as high as 3.4% into 2021, which would translate into a 6.4% Prime rate. But as of December, the outlook has shifted to be significantly friendlier for investors.

A December Wall Street Journal poll of 60 private economists found that the median projection was that rates would top out at 2.93% by mid-2020, before retreating to 2.82% by the end of 2021. The change in outlook is thanks to a number of factors, including trade tensions, expected lower inflation, housing uncertainty, and more.

On the bond side, U.S. 10-year treasury yields hit a seven-year peak of 3.25% in November 2018, but have fallen off significantly since, hitting a low of 2.37% on the way to the current rate of 2.45%. While yields have been falling, for perspective, prior to the 2008 financial crisis, bond yields hadn't seen sub-3.00% levels since the late 1950's. That leaves many believing that, while yield growth may be under control in the near-term, the strong economy we're currently enjoying could lead to a spike. JP Morgan Chase boss Jamie Dimon has even gone as far as to warn investors to get ready for levels closer to 5%.

At the end of the day, these projections are just that - forecasts of what might happen. But if there is one thing that can be said about the times we're currently living in, it's that uncertainty has become king. Remember that none of these factors work in isolation, and all - inflation, interest rates, bond yields, economic growth, etc. - are inextricably tied together. But while we can never know what will happen in the future, a deeper understanding of the factors at play in determining the movement of CRE interest rates allows you to approach investment from a wider, more strategic viewpoint. That can only benefit you - helping to improving your decision making and, in the end, your profits.

Interest Rate Spreads

The benchmark rate is just one factor influencing the interest rate you ultimately pay on your loan. The other factor is the Spread the lender adds to the benchmark. As already stated, the Spread is applied by the lender based on their perceived risk of the loan defaulting. The riskier the loan the higher the risk premium a lender will apply.

While borrowers have no control over the benchmark rate, they can influence what Spread gets applied to their loan by mitigating as much risk to the lender as possible. Keeping LTV's low, having additional assets as security, being an experienced investor/developer, and an excellent borrower track-record, all help your case in keeping the Spread low. Working with an experienced finance broker will also present your loan in the best possible light, and make the lenders more competitive to win your business.

Call or email me if you would like assistance making your next real estate transaction as profitable as possible.

michael@mulcahycapital.com

https://www.mulcahycapital.com

+1-617-861-2042

Mulcahy Capital for Hassle-Free Real Estate Loans.

We provide busy real estate developers, frustrated with financing, better loans in less time, so they make more money.