Can CRE Credit serve as an interest rate hedge in a rising rate environment?

Topics: ,Capital Markets/Commercial Real Estate blog-post

The Federal Reserve is raising interest rates aggressively this year to help slow the highest inflation we have seen in forty years – and it is negatively impacting the bond markets. According to a recent report from Morningstar,

“All major Morningstar fixed-income fund categories are on pace to lose money for a second consecutive quarter. The Bloomberg U.S. Aggregate Bond Index, which comprises U.S. Treasuries, agency-backed mortgage-backed securities, and investment-grade corporates, fell 8.9% for the year through May 31, 2022.” - morningstar.com

This downward pressure on fixed income securities solidifies the importance of diversification and the need for alternatives that have the potential to sustain valuations during rising rate environments. Amid today’s bond market environment, commercial real estate (CRE) credit, especially in the form of floating-rate loans, has unique and attractive characteristics.

Don't Rising Rates Negatively Impact CRE Loans?

Conventional wisdom holds that rising interest rates make CRE borrowing costs more expensive and potentially decrease property values. That being said, cap rates - a valuation metric used to evaluate and compare CRE returns - don't always increase in tandem with rising rates, and CRE valuations may hold steady as economic conditions improve. Also, floating rate CRE loans that provide floating rate financing to borrowers may benefit as rate rise.

Floating-Rate CRE Loans

Unlike traditional bonds, floating-rate loans do not have a fixed interest payment. Instead, rates are tied to a benchmark like LIBOR or SOFR and issued to borrowers at the current rate plus an additional percentage. Here, we'll illustrate how a floating rate loan may behave when rates are rising. Please note that this is a hypothetical example and meant for illustrative purposes only.

A lender offers a borrower a 5.50% mortgage rate on a $10 million loan for a multifamily property (2.00% LIBOR + 3.50% margin).

To provide the funds to the borrower, the lender chooses to finance $7.5 million of the loan by borrowing through a warehouse line with its own bank at a preferred rate of LIBOR + 1.90%). The lender funds the remaining $2.5 million of the loan with its cash holdings.

The spread between the 1.90% margin on the $7.5 million the lender finances and the 3.50% margin the lender charges the borrower is 1.60%. If the LIBOR rate increases from 2.00% to 3.00%, the increase is passed along to the borrower as the floating rate adjusts. And the lender's spread now increases to 2.6%, allowing for an increased yield.

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