Cost of leverage in a volatile rate environment

The headline narrative for CRE borrowers this year has been rising interest rates and their impact on financing costs for both short-term floating rate and long-term fixed rate debt. Looking past this trend of rising rates, we have also observed another dynamic in the rates market that is impacting transaction economics and that has implications for risk management – interest rate volatility. While the trend of interest rates has been up this year, the path of the increase has not been a steady one. As TD Bank's Priya Misra observed in a research note published June 24¹, nearly 55% of daily moves in the 2-year and 10-year Treasury rate year-to-date have exceeded a one standard deviation move. She attributes this volatility to the “dueling narratives” of the twin macroeconomic risks we’re facing – inflation and slow growth, the Fed’s trade-off in policy decisions to influence these risks, and a treasury market structure experiencing declining and impaired dealer intermediation. As the graph below (which shows volatility for the yields on 2-year and 10-year Treasuries²) demonstrates, this volatility is impacting both the short end and the long end of the curve and represents, apart from the start of COVID, the most volatile rates market we’ve seen in the last 10 years.

For CRE borrowers, this volatility is not just of academic interest. For an investor acquiring a new asset, it’s common for there to be a 60-90 day window between a deal going under contract and closing. Assuming leverage is being used, this window represents a period of interest rate risk. A fixed-rate borrower may see the benchmark treasury or swap rate over which their loan prices increase while a floating-rate borrower may see the cost of a hedge, like an interest rate cap, increase. In either case, the borrower closes their loan at a higher interest expense than what was assumed when they went under contract. This year, much more so than in years past, this risk is larger – a borrower is much more likely to see a material change in their cost of financing between contract and close. This reduced certainty adds insult to injury in year where lending spreads have also gapped out significantly.

The graph below shows the yield on the 10-year Treasury back to April 1, 2021, and, for each date, the spread between high and low for the yield over the following 60 business days, this range reflecting the volatility in the yield over this period. Looking at this data, consider the example of a borrower closing a financing with fixed-rate debt priced over the 10-year Treasury. Assuming a 60-day commitment to close window, a borrower signing a commitment in April of last year might expect a range of outcomes for the 10-year Treasury at closing of less than 30 bps; in March of this year this range may have exceeded 120 bps.

The story is similar for floating-rate debt. Short-term rates have swung wildly in recent months as market expectations around the extent to which the Fed will need to raise rates to curb inflation have shifted. The graph below shows the forward curve for 1-month Term SOFR from close of business June 15 (immediately after the last Fed meeting) and the curve as of close of business today. The first shows the market pricing in peak Term SOFR rate of 3.77% by March of 2023, while the latter shows a peak SOFR rate 3.50% by March of 2023.

This volatility in short-term rate expectations has driven volatility in interest cap pricing, which have become a significant driver of loan economics this year. Similar to the graph of the 10-year Treasury above, the graph below shows the cost of a 2-year, 3% cap (in basis points on the loan amount) from April 1, 2021 to current as well as the spread between the high and low cost of the same structure over the following 60 days.

If this volatility continues, CRE borrowers will continue to bear the heightened risk of their cost of debt moving materially between commitment and closing. This risk may be two sided: some borrowers will benefit from favorable rate movements. Though, as we’ve observed advising our clients, borrowers are more disappointed in bad news than they are enthusiastic about good news. The bad news harms more than the good news benefits.

What are the implications for borrowers? In this environment, we'd encourage borrowers to consider the following:

• Understand the magnitude of the risk. If you're signing a term sheet for a fixed-rate loan, we can help you understand how volatile the 10-year Treasury and swap rates have been in recent months. If you're closing a floater with a cap requirement, we can tell you how sensitive the cost of that cap is to interest rates over other market factors, and how much it might change over a certain period of time. This awareness alone may not help you mitigate the risk, but it can help avoid unpleasant surprises down the road or, if the identified risk is truly unpalatable, it might change how you view the attractiveness of the transaction.

• Mitigate the risk when possible. For fixed-rate loans, this may make lender rate locks more attractive and may change how you evaluate loan alternatives, or it may lead you to consider other forward hedging strategies. For loans synthetically fixed with swaps, you may consider swapping the loan early, prior to closing. For floating-rate loans with required caps, you may monitor cap costs and consider purchasing them in advance of requirements. This may be impractical for caps on new loan originations but could make more sense for springing cap requirements or caps purchased in conjunctions with loan extensions.

• Be ready to trade. Nothing is more frustrating than seeing a cap or swap you intend to place hit a favorable level but not be able to take advantage of it. Now more than ever, we are seeing borrowers being strategic on the timing of executing hedges. Chatham can work with you to help you be positioned to trade before you’re strictly required to, typically in a way that doesn’t commit you to anything, which makes for a free option worth pursuing.

At Chatham, we help clients think through the range of interest rate environments they should be underwriting and how to manage risk associated with that uncertainty.