Interest Rate Drops Will Not Solve CRE Problems
Slight rate drops are coming. But that may not necessarily lower mortgage rates.
Investors in commercial real estate and multifamily housing should be less concerned about the Federal Funds rate and more focused on the potential scarcity of capital in the debt markets going forward.
Given the consistent 40-year drop-in mortgage interest rates from 18 percent in 1981 to under 3% in 2021, I think we’ve all forgotten the many potential drivers of these rates. For all the deserved attention on the Federal Funds rate, it seems that many have overlooked an important principle: the Federal Funds rate does not directly impact mortgage rates. Instead, its influence is felt heavily in Treasury bonds, usually 10-year Treasuries, which have historically been a significant determinant of mortgage rates. But not the only one. Factors like GDP, unemployment, housing demand, and inflation also weigh heavily on mortgage rates and often without a direct relationship to the Fed Fund rate or Treasury Bond yields.
Although we all know that modest rate decreases are coming, that may not necessarily lower mortgage rates as much as investors may be expecting.
Confused yet? You are not alone!
Interest Rates Influenced by Many Factors
One reason mortgage rates dropped so low in recent history is that the Fed injected liquidity into the financial system by buying mortgage-backed securities (MBS) and Treasury bonds. Along with lowering the short-term Fed Funds rate, the Fed’s aim was to stimulate economic activity by indirectly lowering long-term interest rates. However, the Fed is now deleveraging its balance sheet. Moving in reverse, it is gradually bringing down its holdings of MBS and Treasury bonds by letting them pay off when due and not buying new bonds with the proceeds, thereby removing liquidity from the system. It is doing this at a time where not only Treasury issuance is at an all-time high, but other sources of capital are stressed and cannot easily absorb the increase in demand. As a result, Treasury Bond rates could remain high and mortgage rates could go up despite the lowering of the Fed Funds rate.
Remember, GDP is strong, unemployment is low, wage growth is stable, and inflation is actually lower than published numbers (due to a flawed methodology concerning the imputed rental cost of housing – a discussion for another day!). By raising the Funds rate, the Fed once again has a tool that helps it manipulate the economy. Slight rate drops are coming. But that may not necessarily lower mortgage rates.
Banks are Constrained
For investors and lenders, $930 Billion in commercial real estate debt matures in 2024, almost all of which will require refinancing at higher rates and lower LTVs. 55-65% of this debt is held by banks, with very little being non-agency CMBS. Approximately $300 million in maturing debt was pushed from 2023 into 2024 – kicking the can further down the road. Debt yield ratios, Loan to Values, and DCSRs are all being calculated conservatively. Appraisals are also lower than when the properties were first financed. With regulators pushing banks to lower their exposure to commercial real estate, there is very little liquidity available for holders of commercial real estate, and what debt is available from banks is on materially less favorable terms. Banks cannot afford to face this issue head on, and like investors, they are hoping rate reductions will fix the problem.
Without meaningful lower rates, investors will have to contribute significantly more equity to refinance their properties – or sell them at deep discounts. This is the ‘ticking time bomb’ in commercial real estate we have all been reading about. Private credit “vulture funds” have seen this and have amassed about $200 billion in capital, ready to pounce.
Despite these concerns, prior to rate increases starting in 2022, real estate equity was at an all-time high as a percentage of value. That helps provide a cushion, and it seems the Fed thinks we can undertake large scale real estate deleveraging without causing significant bumps and bruises to the overall economy. While there may be some discomfort in the real estate markets and with regional banks, Jerome Powell seems willing to accept it.
Rate Reductions Will Not Come Easy
Although it seems likely that the Fed will lower interest rates this year, I think it unlikely that rates will decrease sufficiently to remedy the issues that banks and investors face concerning commercial real estate debt maturities. Bear in mind that Jerome Powell’s tenure concludes in 2026, at which point he will vacate his position. The role of U.S. Fed Chairman holds significant global recognition. Powell is keenly aware of the weight of this responsibility and his legacy. He is determined not to be remembered as the Chairman who presided over runaway inflation, a scenario that could imperil the stability of the U.S. economy.
The lesson of last year is that even smaller banks will not be allowed to fail. The Fed and FDIC will force troubled banks to be absorbed by the big banks or bail them out. However, investors are not too big to fail. I am much more worried about over leveraged private investors than banks and insurance companies. They can handle this. It’s the private investor who will get hammered.
Investors should be concerned about the potential scarcity of capital in the market to allow for a smooth transition from low-cost high LTV real estate debt to lower rates. Private Credit is getting busy but the available capital from these sources is relatively small and expensive.
Although many investors are waiting for rates to drop before refinancing, this may not happen to the level they hope. Capital may become scarce. CRE and Multifamily investors may want to consider refinancing now. The scarcity of funds, driven by the Fed’s balance sheet deleveraging and the inability for other lenders to pick up the remaining volume may indeed drive mortgage rates up or hold them steady despite a decrease in the Fed Funds rate. Capital simply may not be available.
Article courtesy of David Frosh CEO of Fidelity Bancorp Funding
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