Yesterday Once More Part II

Part II: Current Economy and Commercial Lending

by Tony Petosa, Nick Bertino, Erik Edwards, and Matt Herskowitz

AAfter an extended period of declining rates, many borrowers are experiencing for the first time an environment of dramatically increasing interest rates against a backdrop of runaway inflation. The 10-year Treasury yield, after hitting an all-time low of 0.52 percent in August 2020, has since increased seven-fold, hovering recently above 4 percent, with most of that increase hitting this year. Inflation is running at its highest level in four decades, and the word “transitory” has been stricken from

Fed speak. The graph on the following page outlines the 10-year Treasury yield since 1962, reflecting an all-time high yield of 15.84 percent in September 1981. The lowest yield recorded was in August 2020 during the easing of monetary policy following the COVID-19 shutdown. »

Chart showing the daily 10 year treasury yield back to 1962. The 10 year treasury is the benchmark used to decide mortgage rates across the U.S. and is the most liquid and widely traded bond in the world. The current 10 year treasury yield as of July 05, 2022 is 2.82%.

Historical data is provided "as is" and solely for informational purposes - not for trading purposes or advice. Neither macrotrends llc nor any of our information providers will be liable for any damages relating to your use of the data provided. Data courtesy of www.Macrotrends.Net.

With inflation running at its highest level in forty years, many are wondering how high Treasury yields will climb before peaking. In the coming months, inflation will be the key determinate of where interest rates level off, but most are expecting rates to continue to trend higher. In order to be prepared to face a higher interest rate environment, this article will address a few considerations commercial real estate owners should take into account when assessing financing alternatives and structures.

Over the past two decades, a large number of commercial real estate owners, finding interest rates to be attractive by historical standards, elected to finance their properties with long-term fixed rate loans. While these loans offer the advantage of locking in a borrower’s interest rate for an extended period of time (often 10 years or longer), they also are typically structured with prepayment penalties in order to obtain the lowest rate, making it difficult to pay these loans off early. Borrowers who are now in the final years of their fixed rate loans are faced with a dilemma: Should they refinance their properties now and pay the penalties in order to lock in new long-term fixed rates or wait until loan maturity to avoid pre-payment penalties and settle for potentially higher interest rates when they do refinance their properties.

If you find yourself faced with this challenge, it is worth noting that while yield maintenance and defeasance prepayment penalties can be large, generally speaking the penalties decrease as Trea-

sury yields increase and the loan term approaches maturity. If you are nearing the end of your loan term, but not yet in the open window (when the loan can be prepaid without penalty), it may still be a smart move to pay off your current loan early, particularly if you, like many, believe interest rates will continue to rise or if you are accessing additional loan proceeds above your current loan balance. Furthermore, depending on the individual situation, there may be a tax benefit to take advantage of when incurring a prepayment penalty.

However, we would recommend that you consult with your accountant or tax adviser before pursuing this course of action.

The Benefit of ‘Rate Lock’

If you are looking to find a way to avoid paying the prepayment penalty all together, you may want to consider doing an early, or forward, rate lock. Fannie Mae and Freddie Mac offer the ability to lock in an interest rate typically for up to six months in advance of closing. Life insurance companies, which tend to be more selective on asset quality and leverage, can provide forward rate lock options sometimes as long as 12 months prior to loan closing.

It is important to note, regardless of the lending program, a meaningful rate lock deposit (typically 2-3 percent of the loan amount) will likely be required until the loan is funded, and extending the rate lock period beyond approximately 30 days also increases the interest rate spread. Also, most lenders will not want to lock if there are any material underwriting issues to address. Assuming such issues do not exist, a forward rate lock can be a useful tool a borrower can utilize to wait out the prepayment penalty associated with the existing loan and hedge against the risk of upward rate movement.

If you currently have an adjustable-rate loan, you may be able to convert your adjustable rate to a fixed rate or refinance into a fixed rate loan more easily than you think. Most adjustable-rate loans are structured with much more prepayment flexibility compared to long-term fixed rate loans. With Fannie Mae and Freddie Mac adjustable-rate loans, for example, the prepayment structure typically consists of a one-year lockout from prepayment followed by a 1 percent fixed prepayment penalty throughout the remainder of the loan term until the final three months when the loan can be paid off without penalty. In the case of Fannie Mae, the standard adjustable-rate program includes a fixed rate conversion feature that allows the borrower to convert the adjustable rate to a fixed rate after the first year of the loan term. No prepayment penalty is charged at the time the loan converts to a fixed rate, and only minimal re-underwriting is required to confirm that the current net cash flow of the property is sufficient to support the new fixed rate terms.

In the case of Freddie Mac, while their adjustable-rate loans do not provide a fixed rate conversion option, they do waive the 1 percent prepayment penalty if the borrower refinances the existing adjustable-rate loan with a new Freddie Mac fixed rate loan. This is also the case when the borrower on a Fannie Mae adjustable-rate loan refinances into a new Fannie Mae loan. One reason this refinance option can be attractive is that it allows the borrower to pull out additional loan proceeds above and beyond the loan balance on the existing loan provided the cash flow of the property supports it. And, because the refinance is taking place with the same lender that holds the current debt, the refinance process will typically be less onerous since the lender is already familiar with the property, its performance, and the borrower. »

Finance Impact of Rates on Acquisition

As far as acquisition financing is concerned, most commercial real estate investors recognize that cap rates have compressed in recent years, particularly on manufactured home communities, which proved to be one of the most resilient asset classes throughout the COVID-19 pandemic. In order to try to maximize returns, we have seen some borrowers seek out interest-only loans at the highest leverage level possible. However, this type of financing structure in an increasing interest rate environment may be putting your property at refinance risk in the future. While 2007 may seem like a long time ago, it is important to remember that many commercial real estate owners at that time who had taken out high leverage, short-term, interest-only loans found themselves in a proceeds bind when those loans matured in a more conservative lending environment with higher rates. It is worth keeping the tough lessons learned from the last downturn in mind as we head into what may be a challenging financing environment.

In conclusion, the scenarios outlined above are just a sampling of the items one should consider when assessing financing in an increasing interest rate environment. While it is impossible to predict where interest rates are headed in the future, it is often necessary for property owners to make assumptions about where rates might be in the future when their loans are scheduled to mature or when they may want to refinance. These assumptions directly factor into formulating a business plan and assessing whether an early prepayment makes economic sense. MHV Tony Petosa, Nick Bertino, Erik Edwards, and Matt Herskowitz are loan originators at Wells Fargo Multifamily Capital, specializing in providing financing for manufactured home communities through their direct Fannie Mae and Freddie Mac lending programs and correspondent lending relationships. If you would like to receive future newsletters from them, or a copy of their Manufactured Home Community Financing Handbook, they can be reached at (760) 505-9001 (Tony), (858) 336-0782 (Nick) or (760) 402-1942 (Erik); and email: tpetosa@wellsfargo.com, nick.bertino@wellsfargo.com, or erik.edwards@wellsfargo.com

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