The September 17th, 2018 edition of our Rate Watch included some critical historical perspectives related to interest rates and the often-predictive YIELD CURVE. For Commercial Real Estate (CRE) investors both short and long-term rates drive decision making. Assets that require greater flexibly are often financed with floating rate or shorter 3 to 5-year treasury indexed loans. Longer term holds are often financed with 7 to 10 to 30-year fixed treasury indexed loans. The question we are addressing here is how does the yield curve, and specifically, an INVERTED yield curve, impact CRE investment decisions?
Our objective: to help our clients make optimal forward-looking decisions. We try to help clients optimize such decisions by providing historical economic & interest rate data, CRE capital markets conditions, and terms of specific financings from various capital sources.
We believe we are at a critical point in this economic cycle where you may wish to consider current market conditions to best position your portfolio and/or specific asset for the future. We see two factors worthy of consideration:
- The yield curve is extremely flat and may be approaching INVERSION;
- As rates rise spreads may continue to contract, we are beginning see spreads move to levels in the years prior to the 2008 financial crisis
An inversion of the yield curve occurs when the rates on shorter term treasuries (i.e. 2-year treasuries) are higher than the rates on longer term treasuries (i.e. 10-year and 30-year bonds).
Over the past 40 years the difference between the 2-year and the 10-year treasury rates has ranged from 0 to 250 basis points, 90% of the time. During more stable periods the 10-year rate is greater than the 2-year rate on average 135 to 150 basis points. Today it is a mere 26 basis points. This historical difference is shown on the following graph from the Federal Reserve:
Source: Federal Reserve. Note on the graph above: the jagged line measures the difference between the 2-year and 10-year treasury in basis points. When the jagged line dropped below the solid straight black line (which is 0 difference) that’s a period of inversion. The grey shaded vertical bands that follow the inversion are periods of recession.
Short-term rates have been rising at a faster pace than long-term rates. The Fed has been raising the discount rate which drives short-term rates. As a result, the yield curve has been flattening and approaching inversion.
The gap between the 2-year treasury and the 10-year treasury has been narrowing and today sits at only 26 basis points. In June 2018 it was 45 basis points and in March of 2017 it was 130 basis points.
If the Fed continues to push short term rates up as they have stated they will, and longer rates do not follow, the yield curve will most likely invert. As the above chart demonstrates, the past five recessions, and most recessions since the Great Depression, were preceded by an inverted yield curve.
So how does inversion impact financing decisions and why is this important to CRE investors?
History suggests at this point in the economic cycle one of three things will happen to CRE financing rates going forward. We believe it is a critical time to evaluate portfolios and the potential that current choices have to optimize future asset cash flows and values.
We believe the possibilities are:
- the yield curve is going to invert and within 12-24 months we will enter a recession;
- short and long-term rates will rise, bringing the yield curve back to normal levels, or;
- short term rates will decline bringing the yield curve back to a normal state
History suggests that the most likely direction is #1, followed by #2. The third outcome is highly unlikely for the next 18-36 months as the Fed has stated they are raising short term rates. Much of this is supported by historical data all available from the Fed.
In early 2007, CRE debt spreads contracted to 80 to 130 basis points over the index rates (a historic low), and the yield curve inverted. By the end of 2008 we were in the Great Recession. Spreads then ranged from 500 to 800 basis points, for the few Borrowers that were able to obtain credit. In addition, cap rates skyrocketed. It was also a great time for opportunistic buying.
By late 2009 spreads began to decline, and the Fed reduced short-term rates, with long-term rates following suit and declining. Through mid-2016 we lived in a historically low long and short-term interest rate environment which also drove down CRE cap rates.
Today spreads have come in and now range from 95 basis points for very low leverage permanent loans to 200 basis points for higher leverage permanent loans. Credit is abundant (maybe too much so) and economic activity appears extremely strong.
If #1 above occurs, history suggests that on average a recession follows between 12 and 24 months. We believe if an inversion is to occur it will happen sometime in the first half of 2019.
From now until inversion and the beginning of a possible recession, the flat yield curve combined with low spreads presents an opportunity.
This period may be a window to lock in longer term fixed rates on stabilized assets to be held for a long term. The flat yield curve and the compression of spreads currently puts interest rates for long-term money almost identical or lower than short-term money. This dynamic could persist for a 12-24-month period while economic expansion continues.
Conversely, it may be a good time to put shorter term rates in place (3 to 5 to 7 years) if you believe #1 is possible, as most likely rates could will march lower as the Fed lowers rates to lead us out of a recession.
If you believe #2 is the most likely scenario and you have loans maturing in the next 2-7 years you should look at your prepayment penalties now as higher rates will mean lower debt service coverages and higher cap rates which will convert to lower loan to values which could result in reduced loan proceeds.
We are not suggesting you do anything except perform an analysis of your CRE portfolio and/or each individual loan. It is an ideal time to consider these potential scenarios and the impacts they may have on your returns. Now is an excellent opportunity to make the best buy, sell, hold, or refinance decisions for your CRE portfolio and/or individual asset.
We believe the one mistake that could be made is not considering the above and the alternatives available. Several of our clients are having us evaluate their portfolios and individual loans. There is no charge for this service, but this is a very valuable time to evaluate prepayment penalties and determine what is the best financing strategy for the future given the current economic conditions.
Please reach out to us with any questions you may have with respect to the yield curve as well as any portfolio or individual loan requests.