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Financing Strategy in a Rising Rate Environment

Written by: Shawn Hill Posted: 1/30/2017
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On the heels of the Federal Reserve's first rate hike in almost a year and with a new administration at the helm, many investors are wondering what the future holds for commercial real estate and how it might impact their portfolios. There is no denying that investors have benefitted from nearly a decade of unprecedented monetary policy that has held interest rates below historical norms, however investors surely had to know these low rates could not last forever, particularly as the economy has continued to show steady signs of improvement over time.

Starting in 2015 the Federal Reserve began to signal that incremental increases were on the horizon, yet during this period from 2015-2016 there were only two modest 0.25% rate increases, coming at the end of each consecutive year. For 2017, the Fed Funds Rate is likely to continue to move upward, but it is important to remember that the benchmark index is only one component of a borrower’s cost of funds; the other component is the risk premium spread.

In order to gain proper perspective going forward it is often useful to revisit the past as a point of reference. Notably in 2007, the average all-in mortgage rate for self storage assets originated via CMBS was roughly 6.00%; at this time the corresponding Fed Funds rate ranged between 4.25-4.75% and the 10-Year Treasury ranged from a low of ~3.88% to a high of 5.12% over the course of that year. Comparatively, a sample of CMBS loans originated in 2016 had an average coupon of 4.80%, with corresponding Fed Funds Rate at or around 0.25% and a range of 1.37%-2.59% for the 10-Year Treasury. This clearly illustrates the inverse relationship between the forces that affect risk premium spread and the underlying indices that has generally existed throughout time, which is depicted in the table. The good news for borrowers is that CMBS spreads clearly have room to come in as the Fed looks at increases and the benchmark indices for CMBS (Treasuries and swaps) respond accordingly.

The bottom line is that nobody can accurately predict when the Fed will increase rates or where things will shake out over the course of the year, but the general sentiment is that rates are increasing. With that in mind a constructive approach is to formulate a strategic game plan to take advantage of what should still be a great year of historically low rates, relatively speaking, for borrowing. Below are some bullet points to consider as you think about borrowing in the year ahead:

  • Strong CRE Fundamentals: Commercial real estate fundamentals are solid. Self storage rents and occupancies are robust, and cap rates are historically low, so borrowing capacity has seldom been higher.
  • Healthy Lending Environment: Different than the recession, the current lending environment is healthy and favorable for borrowers. Currently the capital markets are firing on all cylinders and there are many options for borrowers seeking debt. Lending options include banks, credit unions, CMBS, life companies, private capital and SBA.
  • Rates Are Low: Interest rates are still historically low. There is never a way to time your borrowing to hit the perfect all-time low rate…instead, take the “bird in the hand” approach and don’t look back.
  • Gradual Increases, Not Spikes: Although the Fed has finally made good on its promise to begin raising interest rates, thankfully they have been very forthright in telegraphing their plan to gradually increase rates over time.
  • Inflation Isn’t All Bad: During inflationary periods, property owners benefit from an ability to push rents, resulting in increasing net operating income (NOI). Self storage owners benefit from the short term nature of the leases, which means you can theoretically push rents to offset the increased cost of borrowing and operating expenses should inflationary pressures take hold.
  • Floating Rate Debt: Borrowers with floating rate debt are more susceptible in a rising rate environment. If you have be riding floating rate loans to take advantage of the low rates now might be the time to consider changing your strategy and locking in to a longer term fixed rate debt product.
  • Construction Loans: If you are planning to build and take floating rate construction debt, be sure to “stress” the rate over the term of the loan. It is better to sleep soundly knowing you have over-estimated the interest carry and operating soft costs during the term than the alternative, which likely means a capital call to your or your investors.

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