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.
Inland Investments is not adopting, making a recommendation for or endorsing any investment strategy or particular security. All views, opinions and positions expressed herein are that of the author and do not necessarily reflect the views, opinions or positions of Inland Investments. All opinions are subject to change without notice, and you should always obtain current information and perform due diligence before participating in any investment.
Inland Investments does not provide legal or tax advice and the information herein should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact any investment result. Inland Investments cannot guarantee that the information herein is accurate, complete, or timely. Inland Investments makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information.
All investing is subject to risk, including the possible loss of the money you invest. In particular, Commercial real estate (CRE) credit and securities investments are subject to the risks typically associated with CRE which include, but are not limited to: market risks such as local property supply and demand conditions; tenants’ inability to pay rent; tenant turnover; economic matters such as inflation and interest rate fluctuations; increases in operating costs; changes in laws and regulations; relative illiquidity of real estate investments; changing market demographics; acts of nature such as hurricanes, earthquakes, tornadoes or floods; and availability of financing. Some of the risks specifically related to investing in a credit fund include, but are not limited to: distributions cannot be guaranteed and may be paid from sources other than cash flow from operations, including borrowings and net offering proceeds; and conflicts of interest with, and payment of fees to, affiliates.