Options for a rising interest rate environment

On May 14, 2018, the 10-year treasury yield broke through the three-percent barrier for the first time since January 2014, aside from a blip in mid-April 2018.  Almost simultaneously, 30-day LIBOR has crept close to two percent for the first time since October 2008. Treasuries have since tapered back down, but the reality that we are in a rising interest rate environment is likely here to stay (baring a major global event). 

This new reality is nothing new, but the joys from low rates over the past eight years are starting to wear off. The good news: The cost of debt is still very low on a relative basis and the financing markets continue to be flushed with capital offering more creative solutions. The yield curve has also flattened allowing borrowers the ability to take advantage of longer-term loans with minimum premiums over what was historically cheaper shorter-term and floating-rate loans. Consumers of capital have many alternative structures, lenders and options available that are very accretive to their business plans, and it’s a good time to revisit asset level business plans and take action where and when appropriate. 

By way of example, Advenir recently converted $172.8 million of Freddie Mac Capped ARM loans to Freddie Mac seven-year, fixed-rates loans in a strategy to mitigate interest-rate risk. According to Steve Vecchitto, managing director and principal of Advenir:

“We have found this to be an opportunistic time to lock interest rates with fixed-rate loans for stable properties that exhibit a long-term ownership horizon. These properties provide substantial current cash flow and continued market appreciation. While the original floating-rate debt allowed for the execution of the value-add business plan upon acquisition, the new fixed-rate debt allows for interest rate stability and a longer hold timeframe for the asset.” 

Advenir is not alone in this action as HFF is seeing this trend amongst clients nationally. Some other trends we are noticing in the market are: 

• Fixed-Rate Bridge Loans:  The bridge loan space has historically been LIBOR based rates and remains to be highly liquid with spreads compressing significantly with the ongoing increases in LIBOR. However, LIBOR is currently around two percent with continued upward pressure on the horizon and spreads haven’t compressed on par with the increases to the index. Many borrowers are locking in rates with fixed-rate bridge financing so they don’t have to underwrite ongoing forward LIBOR curve projections and bear the rising cost to hedge these loans.
• Stretch Insurance Company / Alternative Balance Sheet Loans:  Leverage on agency loans are debt service coverage constrained and with rising treasuries it’s becoming more difficult to hit max proceeds with cap rates as tight as they are. Insurance companies and alternative lenders have stepped up to fill the gap and help borrowers get back to their underwritten leverage IRR’s needed to keep pursuing investments.
• Early Rate Lock / Index Lock:  Many borrowers are taking advantage of the insurance companies and agencies ability to do early rate locks or index locks to take interest rate risk off the table early. These options are nothing new but are becoming more and more valuable as investors continue to pursue investments in this market.
• Numerous Hedging / Derivative Tools:  Borrowers are tapping into the derivatives market to mitigate interest rate risk by swapping the rate, buying a rate cap, collar and many more creative options available in the market. Swapping a floating-rate bank loan can not only fix the rate but can also create value in a rising interest rate environment if the swap is broken before the maturity of the term.

The market is flushed with creative capital solutions that go far beyond what has been highlighted above. This is not a time to panic about rates; it’s time to roll up the sleeves, revisit asset-level business plans, get creative and think outside of the box. Stay nimble and be prepared to take action as opportunities present themselves in a little more volatile interest rate environment. By the time this is published, the market has likely shifted again