By Jim Costello on March 8th, 2022
Less than a month ago, hundreds of real estate industry professionals gathered in San Diego for the Mortgage Bankers Association CREF22 conference which was, for many, the first in-person event since the onset of the pandemic. Participants were optimistic coming off a frenetic pace of mortgage originations in 2021, but there was an undercurrent of concern over future moves by the Federal Reserve and the impact on mortgage rates. At the time, the tensions between Ukraine and Russia were only a side conversation.
Much has changed since then. Russia’s invasion of its sovereign neighbor on February 24 has forced market participants to recalibrate their expectations for inflation, policy changes at the Fed, and trends in economic growth. Despite the uncertainty that is present, market participants need to remain active and make decisions.
Scenario analysis can help with these big unknowns. Team members here at MSCI in a February 28 analysis (before the recent dramatic oil price spikes) looked at scenarios around the impact of the war in Ukraine, with high-yield credit spreads moving up anywhere from 60 to 150 bps from before the conflict. Such changes in the high-yield debt markets would imply more challenging financing situations ahead for commercial real estate.
One thing we can make sense of today, however, is the impact of what the Fed will do next. At the MBA CREF22 conference, there was fear expressed around the topic of what happens when the Fed balance sheet begins to be unwound. While not a perfect analog to the current situation, we can look to a period before the pandemic when the Fed balance sheet was shrinking for some guidance.
The Fed’s balance sheet shrank by $756 billion in peak-to-trough movements between 2015 and 2019. The mechanism of buying up assets in the credit markets to stabilize market pricing was no longer needed by 2015 and the fed funds rate began to creep upward as well. In this 2015-19 time frame, commercial property investment continued, and mortgage rates were manageable.
With support from the Fed fading, there was a steady uptick in interest rates with the 10yr UST climbing from a low of 1.5% in July of 2016 up to 3.2% by October of 2018. In that time frame, mortgage rates for commercial and apartment properties moved some, but the general trend was for a narrowing of the spread between mortgage rates and interest rates. What had been a roughly 280 basis points spread for commercial mortgages in 2016 narrowed to 200 bps by 2018. The spread for apartments narrowed from 230 bps to 170 bps.
Is there room for these spreads to tighten further if the 10yr UST continues to climb? During the depths of the Covid crisis in 2020, the spread between mortgage rates and the 10yr UST hit a pandemic-era high of 330 bps for commercial properties and 290 bps for apartments. This spread narrowed into Q4 2021 as the 10yr UST climbed, hitting 220 bps for commercial properties and 190 bps for apartment. Would lenders at least be willing to accept the same sort of narrower spreads seen in 2018? Perhaps, but economic conditions were different at that time.
The narrower spreads seen in 2018 came about in an environment where inflation was less of a challenge for the economy. The CPI grew at a 1.7% compound average growth rate from 2015 to 2018 versus a 7.5% year-over-year pace set in January of 2022. Again, scenario analysis may be helpful and one might think about the spreads to the 10yr UST that lenders may be able to accept under different conditions for economic growth moving forward. If the current strong pace of economic growth continues, would lenders accept a narrower spread than if the geopolitical turmoil spills over to undermine the real economy?
The war in Ukraine has driven the fallout from the Covid-19 pandemic from the headlines. It was clear at the conference, however, that most market participants have moved beyond Covid even if it is not done with us. The desire to move back to a way of life like that seen before the pandemic may well include mortgage rates at the higher levels that dominated back then.
There is plenty of competition for loan originations, a factor which might help lenders accept narrower mortgage spreads to interest rates. Nonetheless, with mortgage rate spreads today only 20-30 bps wider than the levels that dominated at the end of the last round of Fed tightening, there would simply be far less meat on the bone for lenders today at the current low mortgage rates.
Mike Savino contributed to this article.