True Impact of Higher Rates
Inverted yield curve. Widely followed as a recession predictor, the chart has been in focus since July ‘22 when the 10Y vs 2Y treasury yields first inverted. The script goes that roughly 12 - 18 months from the start of an inversion, recession is nearly guaranteed. By this math, we should be expecting a material economic slowdown no later than Q1 2024. Until then, the current state of inversion caused by the Fed Funds at 4.5% - 4.75%, puts into focus the enormous pressure on floating rate debt caused by spiking yields on the short-end. Floating rate loans, typical debt products for construction or value-add repositioning projects, based on Prime or SOFR, have seen rates sky-rocket from 3.25% and sub-0.5% in 2020 up to 7.75% and 4.5%, respectively, in early 2023.
The impact of higher interest rates on commercial real estate has been widespread. Floating rate deals are stressed on DSCR and have seen free cash gobbled up by higher interest payments. New deals no longer pencil as they used to, leaving buyers with the option of lower LTV or price reductions. Sellers don’t appear to be on board yet with the latter. LTC and LTV have fallen from 70%+ down to 55% for certain deals. All these factors add up to a growing stalemate in transaction activity.
To illustrate, let’s assume a property worth $3mm originally carried $2mm of floating-rate, interest-only debt at 3.5% when it was acquired in 2021. At a 1.25x DSCR, this loan would have needed $87,500 of NOI to comply with this covenant. Fast forward to 2023 with floating-rate, interest-only interest rates now closer to 7%. If NOI benefited from a 20% increase due to a solid 2-year run of inflation, and was now $105,000, interest payments would need to be no greater than $84,000 to cover a 1.25x DSCR. At a 7% interest rate, $84,000 of interest translates to a $1.2mm loan. If this borrower had to refi or roll debt after 2 years, a $800k equity capital call might be required by their lender to right size the loan.
The Fed has so far risen rates faster and higher than any time in history. We’re less than a year into the Fed’s tightening cycle and with inflation still elevated and unemployment stronger than ever, it’s nearly guaranteed more rate hikes are coming our way. If high rates remain in effect for another year or more, the scenario I laid out above might become more commonplace for loans of all varieties, challenging existing borrowers and sidelining new deals. The could leave asset markets in a holding pattern until the new normal for interest rates emerges. Howards Marks of Oaktree capital assumes we’ll see the Fed Funds rate settle in the 2-4% range for the next decade vs 0-2% of the last decade. Hard to argue with one of the best investors of all time.