We all knew the ultra-low mortgage rates seen over the last couple years wouldn’t last forever. Still, the recent rise of a full percentage point over a two-month period left even the steeliest of apartment professionals reaching for their Pepto-Bismol.
From early May to early July, the benchmark 10-year Treasury yield, against which lenders quote most fixed-rate loans, shot up more than 100 basis points (bps), from about 1.6 percent to more than 2.7 percent. Meanwhile, lender spreads—the amount a lender adds to the benchmark to produce a final interest rate—have also widened gradually over the course of the year.
The net result: Fixed-rate quotes were up about 100 bps over the span of 60 days, with the popular 10-year terms typically ranging from the high–4 to the mid–5 percent range, depending on leverage levels and other risk factors.
Of course, inquiring multifamily minds want to know: Was the quick uptick just a temporary overreaction to fears the Federal Reserve will soon scale back its rate-busting bond purchases? And if not, what do these higher rates portend for financing activity and property values?
Historic Lows are History
The consensus among veteran finance professionals is that the higher Treasury yields and wider spreads are indeed here to stay, with the benchmark rising gradually in years ahead as the economy continues to recover.
Yes, borrowers can probably kiss those ultra-low Treasury yields goodbye for now, laments veteran mortgage banker Gary Bechtel, chief lending officer with Business Partners, which funds apartment loans on behalf of credit unions.
And capitalization rates—a key metric used to assess a property’s value—will eventually adjust upward to compensate for the higher financing costs. As mortgage rates rise bit by bit in coming years—assuming the economy continues its slow recovery—today’s compressed cap rates will necessarily need to move northward as well, Bechtel relates.
So, that’s the bad news—cap rates are destined to rise. But here’s some good news: We probably won’t see any significant upward movement in mortgage rates through the balance of the year and into 2014. And that 100 bp–rise over the summer doesn’t appear to have put much, if any, immediate downward pressure on apartment values—so far, at least.
“It would take a more significant change in [mortgage] rates to affect property values,” stresses Jeff Day, CEO of high-volume multifamily lender Berkeley Point Capital, based in Bethesda, Md. “No one seems to fear they’re suddenly losing 10 percent of value.”
And as Day and others point out, the forces that drive these recent rate hikes are actually encouraging to the multifamily sector. The bond market realizes the Fed is bound to ease off its “quantitative easing” and allow for general interest-rate escalation as the job market improves, suggesting even stronger renter demand, and, in turn, higher rents and operating incomes.
While Day anticipates “upward pressure” on Treasury yields over the long term, he’s not anticipating any notable rate hikes over the coming six to nine months. However, he warns of likely near-term “volatility” in Treasury and mortgage-backed securities yields—and, in turn, apartment mortgage quotes.
Winners and Losers of Higher Interest Rates
Echoing his peers, longtime apartment investment manager Bob Hart dubs the recent uptick in fixed debt costs as something of a fundamental “reset” of mortgage rates. The roughly 100 bps rise in fixed-rate coupons seems to hail “a return to more rational pricing,” says Hart, who recently left Beverly Hills, Calif.–based Kennedy Wilson Multifamily to form Los Angeles–based TruAmerica Multifamily in partnership with The Guardian Life Insurance Co. of America, headquartered in New York City.
But higher debt costs affect some investors more than others. And the consensus among finance pros is that institutionally backed outfits will be the beneficiaries. Private entrepreneurs needing to maximize leverage will have a tougher time competing with deep-pocketed players on acquisitions at the higher financing rates.
“If we see more pressure on all-in coupons, it’s going to affect the private high-leverage investor’s ability to buy at prevailing cap rates,” observes Elliott Throne, a Miami, Fla.-based director with capital markets intermediary HFF. Indeed, he’s already witnessed at least a few highly leveraged pending transactions fall by the wayside.
“On the other hand,” Throne continues, “the low-leverage investors stand to benefit from the movement in rates, because it will eliminate some of the competition from buyers who have been able to bid so aggressively” under the ultra-low–rate environment.
Certain borrowers will adjust through various strategies such as opting for floating-rate debt over fixed; engaging in a little “duration migration” and using five-year loans instead of 10-year mortgages; or choosing interest-only periods over full-term amortizations.
The rise in interest rates will also likely cause a chain reaction in the competitive landscape of the lending community.
Fannie Mae and Freddie Mac will probably further boost rates as they grow more selective in meeting their shrinking volume goals. This will allow life companies to become more aggressive in their preferred sweet spots (low-leverage, high-quality assets). And this also gives conduit lenders a chance to boost their market share by offering leverage levels (and, in turn, loan proceeds) beyond where other lenders dare.
Of course as most agree, embracing the various early rate-lock and forward-commitment mechanisms available is something of a no-brainer in a rising-rate environment.
“When rates become volatile, the sooner a borrower can take rate risk off the table, the better,” Day stresses.
LIBOR Dances the Limbo
Experts also point out that while quotes for fixed-rate mortgages have jumped sharply, ongoing efforts to keep the London Interbank Offered Rate (LIBOR) index down have kept short-term floating rates stable—and exceptionally low.
The Treasury yield hikes have pushed fixed-rate apartment mortgage quotes typically to plus-or-minus 5 percent on leveraged 10-year deals, with comparables for generally less-popular five-year transactions running 100-plus basis points lower.
But with the Fed indicating it will keep the federal funds rate target at near zero for another year or two at the minimum, the LIBOR floating-rate indices haven’t budged. The one-month LIBOR rate remains not far from zero, at less than 0.2 percent.
Meanwhile, quoted spreads on construction debt haven’t widened noticeably. But construction lenders are predictably adjusting proceeds slightly downward to compensate for the higher permanent rates developers (or buyers) are likely to encounter at take-out.
And the uptick in bond yields hasn’t yet affected rates on construction/permanent loans guaranteed through the Federal Housing Administration’s Sec. 221(d)(4) and related mortgage insurance programs, Day adds.
Cap Rates to Rise
A sudden 100-bps rise in interest rates doesn’t suggest a corresponding property-value decline. Not yet anyway. But finance professionals agree that cap-rate adjustments are inevitable with any further debt-cost escalation.
To wit, a just-released white paper from CBRE Econometric Advisors projects that income-property cap rates generally should remain “relatively flat” through the end of the year and perhaps well into 2014. However, as interest rates continue to climb gradually, cap rates are likely to climb somewhere between 70 and 113 bps higher than they were in the first-quarter 2013 levels by around the middle of 2015.
Market-rate apartment cap rates have been at or near all-time lows over much of the past year amid strong supply–demand fundamentals and low financing costs. Many deals have been trading in the vicinity of 5 percent but have come in as low as the mid-3s just in the past couple months.
As for active apartment lenders, Fannie Mae and Freddie Mac’s mandate to reduce balance-sheet exposure and shrink originations will open up more opportunities for other players, Hart and others suggest. And with the upward movement in all-in interest rates, the life companies seem especially well positioned to write more loans secured by high-quality collateral, he adds.
Meanwhile, banks and locally minded savings institutions such as credit unions will have better shots at the smaller apartment loans Fannie Mae had been targeting, Bechtel foresees. And as rates continue upward, Day wouldn’t be surprised if conduits step up and offer higher proceeds (but likely higher rates, as well) than the GSEs or life companies are willing to provide for a given transaction, especially in secondary markets and Class B and C collateral.
“So we may see more of a shift in market share than any decline in deal flow,” Day notes.
And while nobody knows when this current upturn will peak, and values will reach their zenith, the rate movement seems likely to convince some owners to move properties sooner rather than later.
“If you’re not aiming to hold long-term and thinking about selling within the next few years,” Throne advises, “you might think harder about selling today.”