Source: RE Business Online —
After eight interest rate hikes totaling 450 basis points over the last 10 months, courtesy of the Federal Reserve’s war on inflation, commercial borrowers can only hope that the fundamental law of gravity — “what goes up must come down” — will start to become reality in 2023.
But the economic clarity that the commercial lending community seeks is muddied by conflicting agendas. On the one hand, the nation’s central bank has made some headway in taming inflation through the rate hikes. The Consumer Price Index fell from an annual rate of 9.1 percent in June 2022 to 6.5 percent in December, but is still well above the Fed’s 2 percent target rate.
On the other hand, expansionary fiscal policy such as the $1.2 trillion infrastructure bill signed into law in late 2021 and the $1.7 trillion omnibus appropriations bill passed in December 2022 could undermine the Fed’s efforts to curb inflation, say some economists. The U.S. national debt stood at a record $31.5 trillion as of press time due to the cumulative effect of recessions, wars, tax cuts, the COVID-19 pandemic, and excessive government spending. The ratio of U.S. federal debt to GDP as of press time was 120.3 percent.
Against that backdrop, direct lenders and financial intermediaries across the commercial real estate industry do anticipate some slowdown in the frequency and magnitude of short-term interest rate hikes in 2023. But for borrowers seeking to refinance their assets or in need of acquisition or construction financing, hope and expectation aren’t much to hang their hats on.
Patience is a Virtue
Borrowers are looking for outside-the-box solutions to reshape their capital stacks, such that the impacts of numerous interest rate hikes can be minimized. For those that can afford to do so, the simplest solution is also the most effective: just sit tight.
“The ‘hurry-up-and-wait’ strategy is still relatively rampant, especially with borrowers that are institutional companies,” says Igor Zhizhin, president at American Street Capital, a Chicago-based mortgage banking firm.
“For clients that are in floating-rate products and feel comfortable with a potential addition of 75 basis points and are pursuing a sale or refinancing in the next 12 months, we advise avoiding the urge to refinance for the next six to nine months,” he continues. “For those with loans that are set to mature in the next six months and aren’t willing to take on floating-rate interest risk, we suggest refinancing into two- or three-year fixed terms.”
Zhizhin points out that for highly liquid borrowers, simply doing nothing for the next 12 months is better than attempting to refinance into long-term fixed solutions in anticipation of more rate hikes in the future. That’s because the majority of fixed-rate loans carry exorbitant prepayment penalties.
By enduring some pain in the short run, borrowers hope to put themselves in positions to secure long-term, fixed-rate debt in 18 months or so, when rates have presumably come back to earth. Zhizhin refers to this solution as “mini-permanent debt,” which is designed to give most — not all — borrowers opportunities to simply remain on the sidelines.
“Over the long run, especially for borrowers whose business plans have timelines of seven years or more, the benefits of eliminating interest rate risk by refinancing now are really going to come home to roost when rates come back down,” explains Zhizhin. “Getting a 10-year, fixed-rate loan today would likely be in the mid- to high-6s. You have to weigh that against starting in the mid-5s in one to two years and not being able to get out of it without a hefty and prohibitive prepayment penalty.”
“Everyone is pushing for fixed-rate debt with bank balance sheet or fixed-rate life insurance products versus conduit financing with defeasance or yield maintenance and structured prepayment,” concurs Charles Penan, executive vice president at Aztec Group, a Miami-based intermediary. “There’s always some debt maturing and some transactions happening. But unless an owner has an acute need to transact today, we’re advising them to wait. The question is for how long?”
“Based on our conversations with lenders, we do expect rate hikes to plateau or even decline by the end of 2023 — though that doesn’t mean spreads will go down,” Penan continues. “So, if a borrower is comfortable at a 6 percent interest rate, we advise the borrower to roll with it, because nobody knows what the future holds.”
When Waiting Isn’t Feasible
To hedge against market volatility, borrowers that are not able to simply “wait it out” must be willing to accept equity infusions or shifts to short-term debt structures. That means giving up a percentage of ownership of an asset or paying higher interest rates over the next 12 to 36 months.
But that willingness to be flexible in the short term could save millions in interest payments later down the line. Further, outside of those basic avenues of relief, borrowers have little recourse but to sell their properties, presumably at discounted prices in some cases. Otherwise, they risk defaulting on their loans and possibly going into foreclosure.
“We are seeing and hearing about recapitalizations and restructurings. We expect to see more of that in the coming months as a lot of borrowers can now foresee a need to address those scenarios,” says Ross Pemmerl, chief credit officer at UC Funds, a Boston-based lender that primarily plays in the value-add multifamily space.
