Tis the season! Holiday shopping, World Cup soccer, football, and of course headlines about the Federal Reserve potentially tapering the pace of rate hikes and maybe – just maybe – getting inflation under control. With a yield curve that first inverted in July of this year, it’s long been on my wish list ​ that we start to see a downward trend in interest rates as the Fed takes its foot off the gas pedal.

Before we start to address lower CRE borrowing rates, how about a quick refresher about the way many lending institutions price their loans -- especially if they don’t have dry powder keg at their disposal?

How do CRE loans get priced? The wizard behind the curtain

We are all keenly aware, the Fed has served up six separate rate increases over the past nine months (totaling 375 basis points) in hopes of slowing inflation. The current Federal Funds Rate is 3.83%, but what is the actual cost for lenders to borrow from Uncle Sam and from each other? The secret sauce is the Fed Funds Target Rate (FFTR) currently sitting at a range of 3.75% to 4.00%

If a bank is flush with deposits, it may lend money to the Fed. That’s what the Overnight Reverse Repo Facility (ON RRP) is all about. The ON RRP is the rate that banks receive when they lend money to the Fed overnight, typically five to ten basis points above the bottom of the Fed Target Rate.

Since the borrower is the U.S. government, this type of lending is considered risk-free and sets the bottom of the Fed funds rate trading floor. The discount rate (aka “borrowing from the Fed Window”) is the rate the Fed charges for banks to borrow overnight. This is usually at the top end of the FFTR range and was at 4.00% as of December 7th. Since a bank can borrow from the Fed at this rate, it effectively sets a ceiling for the Fed’s Target Rate.

Now that we know what it costs a bank to borrow from the Fed Window to make a loan, let’s discuss the second part of the equation: the bank spread. The bank spread, combined with the Fed Window rate, gives us the fixed rate coupon! The holy grail for a borrower is to find a lender requiring the smallest spread and who will rate-lock the borrower at application to take any additional risk off the table.

More easily said that done, however. That’s why my capital market team “behind the curtain” at Ascension exists!

As Commercial Observer reported last week, banks have been reluctant to underwrite loans ever since the Fed announced the first of four consecutive jumbo rate hikes in June. Those moves brought the Fed window rates to a range of 3.75% to 4.00% compared to the near-zero short-term borrowing in early 2022. Adding fuel to the fire, the Fed is raising its target range on the overnight borrowing rate by 50 basis points. Those lower Treasury rates that came home for the holidays in the form of a 60-basis point downward swing may just not hold in the short term.

As a result of these persistent rate hikes, an Institutional Property Advisors (IPA) report opined that the capital markets have responded with “overwhelming caution until there is clarity on when the Fed will stop and where interest rates are likely to settle.” IPA further indicated that stock market volatility, geopolitical risk, decelerating rent growth, falling home prices, and cap rate inflation uncertainties have clouded the picture as both lenders and investors take a pause to raise funds for what they believe will be “impending distress” in CRE, much as we saw with onset of the pandemic in 2020.

While it’s true that some lenders have elected to sit it out on the sidelines until Q1/23 for a myriad of reasons, Ascension’s pipeline of opportunities continues to find attractive financing rate and terms. The financial system for middle market CRE lending is still healthy; you just need to look under the right rocks and move the right boulders.

Commercial Observer said that with large banks on the sidelines, many borrowers are instead seeking transitional loans at higher interest rates. Goldman Sachs’s Miriam Wheeler told Commercial Observer that many banks “dramatically increased” their CRE exposure in the first half of 2022 and now have backlogs they need to sell in an uncertain environment. As a result, Wheeler said those banks are cutting back on lending as they “prepare for a possible recession in 2023.”

From where I sit, slower growth is on the horizon and that will likely impact stocks negatively and create a heyday ​ for beaten down bond prices. Recession fears have been fanned by one of the most extreme yield curve inversions that we’ve seen in decades. As The Wall Street Journal recently reported: Yields on longer-term U.S. Treasurys have fallen 0.78% below those on short-term bonds, the largest negative spread we’ve seen since 1981. According to The Journal, that’s a sign that investors think the “Federal Reserve is close to winning its inflation battle regardless of the cost to economic activity.”

Addressing the recent rate pullback, strategists at Evercore ISI told The Journal this week that it’s likely long-term Treasury yields “would be lower still if the Treasury market was discounting a high probability of anything worse than a mild recession.” What that means to me is that another rate increase by the Fed, while less severe than what we’ve been seeing this year, may still create short-term turbulence in CRE pricing. There is no avoiding the steepening of the inverted yield curve. I strongly believe rates will fall in 2023 as the market expects Fed cuts to restart the economic engine that it choked off with its inflation fighting policy moves in 2022. ​

While a recession is feared in many corners of the economy, it can be beneficial for CRE and SFR if it means the Fed will finally start easing up on rate hikes. As The Journal opined: “The Fed’s efforts to slow the economy in great part depend on the housing market slumping, because that cools off demand for goods and services, and because housing itself is an important contributor to inflation.”

As the Fed starts to ease up on rate hikes and it becomes apparent that inflation is rapidly decelerating, IPA predicted that bond investor sentiment will improve, “leading to tighter spreads on CMBS and CLO tranches.” IPA also predicted that spreads should decline on both CMBS perm loans and light transitional bridge debt, and that narrower spreads may offset some of the future Fed rate hikes in the base rate. “This will lead to all-in rate levels not too dis¬similar to those obtainable now,” forecast IPA, “but with the added benefit of increased lending options and competition. Eventually, the increased competition will lead to more bridge lenders providing financing on more highly transitional assets and less desired product types.”

As I like to remind our team, it’s a natural part of our market cycle to find better pricing and terms as lenders benched by a volatile bond market jump back onto the field. Increased competition always drives better deals for the consumer. It’s no different in CRE lending.

Just remember, many financing decisions are driven by inflation data – and that data tends to lag current reality by six months or more. Here in the Holiday season, data is suggesting that inflation is coming down more than current CPI figures would have you believe. Just look at major drivers of inflation, such as housing costs and rent, which have been declining nationwide.

As IPA predicted: “The Fed should eventually start to indicate a slowing or stopping of rate hikes, after which lending will pour back into the market in force. This could potentially drive down spreads faster than expected, due to the amount of liquidity already present and growing for CRE transactions,” IPA added

Conclusion

Lower rates are home for holidays. From my vantage point, they will stick around like the fruitcake my father always sends me. As my 5-year-old eagerly awaits both Santa and the lighting of the Chanukah candles, he’s been humming strange Kwanza songs picked up in kindergarten. It’s a good metaphor for CRE lender at the moment: good things are coming, even though the current environment is a bit unfamiliar. May you all have a warm and joyful Holiday season as we look to a very a healthy rate environment in the New Year.