Where Financing Might End Up

We have a client who bought a building a few years back and had floating bridge debt tied to SOFR. A rate cap had been running several thousand dollars a month and there’s been an escrow review every six months. After the most recent one, the lender insisted on a new rate cap—which had gone up by a factor of ten. More than $30,000 a month. The client didn’t want that big a hit on cash flow and so sold the property in time.

That’s by way of introduction to the minutes of the September Federal Reserve’s Federal Open Market Committee (FOMC)—more colloquially known as the people who vote on rate hikes—are out. Anyone hoping for a sign that the Fed felt it had done enough is going to be disappointed.

“Wednesday's minutes report confirms the Fed's commitment to fighting inflation. The Fed has to keep talking about and implementing additional rate hikes, otherwise all it’s done to fight inflation up until now is wasted baggage,” wrote George Ball, chairman of investment firm Sanders Morris Harris in an emailed note. “While inflation has peaked, the path to a 2% inflation rate will be long, windy and bumpy.” The even shorter summary to the 12-page minutes: “The Federal Reserve's current tone suggests it is committed to raising interest rates until the snake of inflation is dead.”

All this is before inflation data. “Should tomorrow's Consumer Price Index (CPI) print come in above what the market is expecting, today's somewhat blasé reaction to the minutes, and the PPI report, could be tested, particularly by bond yields,” said Quincy Krosby, Chief Global Strategist at LPL Financial, in a separate emailed note.

Maybe the pressure will come off some at the Fed’s November meeting if things continue to cool. The Fed did say that if things showed enough improvement, it would begin to moderate the hikes. Although between the September jobs report, while somewhat cooled still showed significant growth, and the latest PPI report with a sudden jump in producer prices, there’s now even more pressure on other indicators to show the economic slowing the Fed wants.

We spoke with a friend of Offerd—Jeremy Nussbaum, Senior Director of Capital Markets at Walker & Dunlop—about the current conditions.

“More than anything right now, it’s just extremely volatile in regard to indexes moving way more than what we have seen historically” Jeremy says. “The 10-year going up or down 20, 30, 40 basis points every day—it’s made everything really challenging. What are assets worth today? How do you figure that out with all the volatility. It’s difficult on the finance side of things because you have a moving target on rates and pricing.”

That, of course, could change on a dime with a sudden wind shift by the Fed. But it’s not something you could count on—and, in the long run, not something you necessarily need to see change, so long as there’s greater stability in expectations. “The more stability we have, even when rates are high, the more markets will adjust accordingly” says Jeremy. “When you have wild swings, no one knows how to react.”

Right now, there are rising rates, of course, and multifamily investors and operators need to pay close attention to how their projects got to where they are today.

“There is a significant amount of floating-rate bridge money that has been put out for what we labeled ‘value add’ multifamily opportunities. Most of those loans required rate caps.” And, at this point, many of those caps are nearing the end of their term and costs for new caps are extremely high. Will sponsors and investors underwrite the extra capital needed in addition to that required for rising rates?

The “massive rent growth” over the last several years has offered some financial saving grace, he says, showing that not all surprise is bad. “I would surmise to say it was significantly above most projections as buyers were going into deals. From an industry type perspective, I’d say the rent growth was enough to carry these deals through this high-rate environment.” That’s assuming the Fed eventually cuts back in 12 to 18 months.

The ultimate result is likely to be interest rates for CRE investors that are in keeping with historical norms, but also that are higher than many had become accustomed to.

“Compared to the last 10 or 12 years, we’re certainly above the average,” Jeremy says. “I’ll tell you my general thesis, which is not based on much of anything, but I feel a market interest rate is in the low 4s to mid 5s, where people would feel comfortable. Cap rates would be normalized somewhat. But are we going back to 3s and even high 2s? Certainly not anytime soon.”

He adds, “I think we will see many deals that are not in a position, with enough cash flow, to get into a refinance. Their next best option is to sell the asset and try to recoup as much equity as they can.”