By Jim Costello on March 16th, 2017
The impact of the Federal Reserve’s 0.25% interest rate increase on investors is unclear. However, for lenders this environment of increasing short-term rates presents challenges to their profitability.
Lenders make a living off of the slope of the yield curve. When the curve is steep, they can borrow short at low rates and lend it long at higher rates. When that spread narrows, lender profits shrink.
Of course, not all lenders are simply borrowing this ultrashort debt from the Fed and lending it long term. Lenders will have a mix of capital sources, but the fed funds rate – now increased to a 0.75-1.0% target range – is instructive as a benchmark because it shows an extreme point on the yield curve.
Looking at the spread between the fed funds rate and the benchmark 7-10yr fixed commercial mortgage rate from Real Capital Analytics, banks are starting to face profitability challenges that – all other things being equal – should lead them to try to push up mortgage rates.
The best time to be a commercial real estate lender was back in ‘09-‘10. With the fed funds rate between 0.10% and 0.15% and commercial mortgage rates above 7% for a time, there was more than 700 bps of spread on these loans relative to this short-term source of financing. As the economy improved and competition from lenders increased, this spread narrowed to an average of 427 bps in ‘14 and ‘15. Into February ‘17, this spread narrowed to 390 bps.
This narrowing suggests that at the mortgage rates on offer today, lenders are simply earning less than in the past. Is 390 bps of spread appropriate for the risk they are taking on today? Was 427 bps an appropriate spread? Since October ‘16, the fed funds rate has gone up 26 bps while fixed-rate mortgages have answered with a 23 bp increase.
Clearly in response to the higher rate environment lenders are trying to maintain profitability by pushing higher mortgage rates. Following yesterday’s move by the Fed though, will lenders be able to push mortgage rates up a corresponding 25 bps? Borrowers may not let them and may instead opt for other financing structures.
The impact for borrowers can be measured less directly but the change can certainly be as influential.
In our US Capital Trends report to be released next week, we show that since 2014 – as the mortgage rates on RCA’s benchmark 7-10yr index increased – borrowers have been increasingly taking on variable rate loans, both for acquisitions and refinancing. This move to variable rate loans gives borrowers lower rates which in turn allow them to have deals pencil out even with the current low cap rate environment. Should interest rates continue to climb though, these borrowers are taking on a higher level of refinancing risk.