A Comprehensive Analysis of Today’s Capital Markets & Trends
(Part 2)
Written by Ryan Gray, Executive Vice President of Investments & Acquisitions at Carter Funds |
Forward curve model remains an important base case for underwriting and experts expect a downward shift in 2024 rates.
Evidenced by forward curve expectations, Chatham Financial has tracked past forward curves against Libor/SOFR rates. As demonstrated in the following chart, in December of 2021, market expectations were for SOFR to remain below 1.5% thru December of 2024. In the six months following December 2021, the Fed approved its third rate hike on June 16, 2022, taking the Fed Funds rate from 0.25%-0.5% to 1.5%-1.75% surpassing widely held market expectations. Forward curve expectations skyrocketed to 3.5% and then 4.5% for year-end 2022 but fell short of the Fed’s actions.[1]
1-month USD LIBOR vs. Historical Forward Curves
CBRE suggests that easing inflation supports their prediction that the Fed is likely done raising rates, and by Q1 2024, will begin to cut them as economic growth slows and inflation moves closer to the central bank’s 2% target level.[2]
Hedging and derivatives markets anticipate smoother times ahead.
The fallout of this rapid rise in the curve is still reverberating throughout hedging and derivatives products and markets, but is expected to gradually stabilize over the next year. Borrowers that largely relied on the high leverage floating rate debt products of Debt Funds and CMBS lenders experienced, firsthand, the impact this would have on the cost of interest rate caps. In February 2022, a borrower could purchase a rate cap at a strike rate of 2.5% for a cost of $188,000, representing 42 basis points on a loan amount of $44.5M. At the time, their index would be capped at 2.50% plus the then SOFR rate of 0.08%. In less than 8 months, that cost would increase over 1100% to $2,088,000. Based on today’s forward curve, $213,000 would purchase a rate cap with a strike rate of 5.5% on the same loan amount.
|
Interest Rate Cap Costs |
|||
| Notional Amount | $44,500,000 | ||
| Term | 2 Years | ||
| 2/18/2022 | 7/28/2023 | ||
| SOFR | 0.08% | 5.31% | 5.31% |
| Strike Rate | 2.50% | 2.50% | 5.50% |
| Cost | $188,000 | $2,088,000 | $213,000 |
| Cost/bps | 0.42% | 4.69% | 0.48% |
This rise in hedging costs is directly affecting borrowers by increasing required lender escrows for the purchase of replacement interest rate caps, which is diverting cashflow from investors into reserve accounts and creating negative cashflow situations. In addition, the availability of liquidity in the debt markets has been severely hampered by banks posturing to protect balance sheets, while conduit lenders and markets have slowed if not halted while unable to sell tranches of CLOs to traditional buyers.
Market disruptions can create higher yield opportunities for sophisticated buyers.
As a result, we are seeing fewer active capital market participants, however, multifamily continues to benefit from the availability of liquidity provided by the existence of Fannie Mae, Freddie Mac and HUD lending products. Since 2015, commercial real estate investment was largely buoyed by the availability of high leverage lending products and historically low interest rates (fixed and floating), which are largely absent in today’s market. That absence has driven undercapitalized market participants to the sidelines, both in terms of smaller lenders and smaller investors. Institutional investors are patiently sitting in substantial cash positions as they await buying opportunities with higher yield expectations that are anticipated by further financial market disruptions.
All of these fundamentals are driving market imbalance, and as a result market cap rates have risen by as much as 125 basis points from the market low. We expect the market disruption to continue until the Fed is forced to cut rates, but until then, many owners are facing hold or sell decisions. With the current state of the capital markets, many sellers will be compelled to sell by necessity.
With our team’s robust expertise in investing, commercial real estate management, and multifamily property operations, along with our industry relationships, Carter Funds is well-prepared to navigate current market dynamics. Our strategic approach to acquisitions, coupled with resource optimization, positions us to seize the unique opportunities that lie ahead.
Stay tuned for more “Thought Leadership Series” articles in the coming weeks.
[1] https://www.chathamfinancial.com/insights/libor-forward-curves-historical-accuracy
[2] https://www.cbre.com/insights/briefs/economic-watch-annual-inflation-lower-than-expected-in-july
