The dramatic rise on the yield of the 10-year Treasury has sent all-in rates from the government-sponsored enterprises (GSEs) rising as well.
In early October, the 10-year Treasury was as low as 2.41 percent, and borrowers could score 10-year GSE debt in the low- to mid-4 percent range. But on Dec. 2, the benchmark rate rose above 3 percent for the first time since July. That increase—coupled with investor spreads rising between 10 and 15 basis points (bps) over the last month—has sent the all-in rate for a 10-year GSE loan closer to the low-5 percent range.
Full leverage five-year loans from the GSEs are quoting above 4 percent, and seven-year loans are inching closer to 5 percent. Those are still great rates by historical standards. But it’s a drastic increase in a short amount of time. And that rising interest-rate environment is likely to have an impact on cap rates and the acquisition market in general heading into 2011.
“When there’s a dramatic upward movement in rates, you will get a fairly dramatic slowdown in transactions,” says Don King, national production manager of agency lending at Boston-based CWCapital. “If you’re in acquisition mode, and within the course of less than a month your note rate climbs 50 bps, that has a pretty severe impact on your underwriting. The return on equity has to be impacted.”
Debt proceeds haven’t yet been affected, particularly since Fannie Mae lenders are using an underwriting floor to size loans and today’s rate hasn’t yet hit that floor. But the impact on the acquisition market will likely be felt.
“Debt really does, in a lot of circumstances, control pricing,” says Mike Kavanau, a senior managing director for Holliday Fenoglio Fowler’s Chicago office. “If you have sustained upward moving rates for a period of time, cap rates follow as a general rule. Any time rates move really fast, it tends to not be great for the leveraged transaction business.”
In some ways, it’s the instability of rates, and not so much the rate itself, that will likely have an impact on the transaction market. In a stable interest-rate environment, buyers and sellers have time to adjust. But a sudden, dramatic swing in rates throws everyone off guard.
“When you have a stable environment, even if it’s 50 bps higher than it is today, you’ll see cap rates make the adjustment to that new level,” King says. “It’s just particularly painful while the market is changing.”
Of course, the GSEs will often tighten their spreads to lower the overall rate whenever the benchmark climbs. But that hasn’t happened yet. And the GSEs have all the business they can handle at the moment. Consider this: Through the first six months of the year, Freddie Mac processed about $3.6 billion in loan volume—in November and December combined, they’re looking to close around $4 billion.
Underwriting Trends for 2011
Most agency lenders don’t expect any big changes in the way Fannie Mae and Freddie Mac underwrite deals next year. After loosening up in the spring—more readily granting waivers and offering partial interest-only (IO) again—the GSEs will likely just make incremental changes next year.
Fannie Mae is hoping that improving fundamentals will allow it to take some markets off its pre-review list. In the past few years, many markets were added to the list. When a market’s on pre-review, underwriting metrics are much tougher and lenders must get a deal approved by Fannie Mae headquarters before they can close a loan, which slows down the process.
“I suspect that as some markets improve, there probably will be some room to take some markets off of pre-review,” says Manny Menendez, a vice president at Washington, D.C.-based Fannie Mae. “We’re looking for opportunities where we can delegate more authority to our lenders. We’re trying to calibrate the waivers and see if there are situations where we can provide more delegation back to the lenders.”
And next year, Freddie Mac plans to make its refi test—a stress test in structuring loans that looks at the ability to refinance at maturity—more transparent to its lenders and borrowers. Ultimately, that test determines the size of a loan and additional factors such as how much IO will be offered. But in the past, it was a black box—neither a borrower nor a lender knew exactly what assumptions went into the refi test.
Freddie Mac lenders are split as to whether the new transparency means the refi test will become more borrower-friendly, or if it’s just a matter of the GSE managing borrower expectations.
“Beyond the transparency, I think the test is going to be more liberal in terms of the interest-rate assumptions or other exit assumptions, and that should allow for more IO right off the bat,” Kavanau says. “And if they do it, then the life companies are pretty certain to follow.”