“No one rings a bell at market tops or market bottoms” – Wall Street adage
I’m calling my shot. They are ringing the bell. Interest rates will rise in the second half of 2014 and continue to rise in 2015. While the Federal Reserve was able to postpone the inevitable by its continuous purchase of U.S. Treasuries since 2009, the Fed’s announcement of its intent to start to taper those activities should have been met with more of a reaction by the Treasury market. While there was an initial knee-jerk bump in rates in January 2014, with the 10-year Treasury hitting 3 percent for the first time since the summer of 2011, the market has become sanguine (the 10-year retreating to roughly 2.7 percent) as investors have become conditioned to expect that interest rates will remain low and the Fed will have their back.
Really? Check the chart below. It helped that the Fed back-tracked from its initial comments when it saw the market reaction but how long can that last? Wall Street legend Art Cashin, director of floor operations at UBS, recently said that “The great fear is contagion… The first thing that an investor should look at when he wakes up in the morning is the 10-year Treasury”
The above chart helps illustrate just how severe the Fed money printing has become. It won’t be long before economists capitulate to the Occam’s Razor theory–that the simplest answer is usually the correct one–and thus hyperinflation is around the corner. So what to do if you are a real estate property owner?
Well, the reason many are still financing their properties with floating rate debt is the fact that they have been using LIBOR as a base rate, which has been below 1 percent for over five years now. I have a client who owns apartment buildings in Manhattan and has financed them all through a German Bank at LIBOR plus two percent.
This theme has become the drug that has fueled our industry’s comeback, but the music will stop (or at least slow substantially) when LIBOR inevitably spikes as investors scramble to lock in rates. The obstacle is that it will be like a crowded theatre when this occurs and lenders will be able to pick and choose their prospects.
More importantly, higher rates will mean that debt service coverage will be tighter and thus loan proceeds will be reduced. Why would an owner risk this? As I tell my clients, your expertise is in real estate, you aren’t a bond market speculator.
If you can lock in historically low long-term interest rates today, why wouldn’t you do it? And if the answer is that one wants the flexibility to sell the property, the financing in-place will be an asset to any buyer when interest rates go up (so long as the mortgage is assumable).
Obviously, the in-place financing would not be an asset if interest rates were to go lower from here, but I think we could all agree that the upward risk is much greater than the downward movement of interest rates. See the historical 10-year Treasury chart.
For property owners who are hesitant to lock in interest rates because it could increase their monthly debt service in the short run (versus a floating rate over LIBOR), I ask them if they would be willing to play in the interest rate commodities market on Wall Street.
If the answer is “no, that isn’t my business,” then it shouldn’t be your business to keep floating rate debt on a fixed rental income stream. And if, for some reason, you don’t want to go through the hassle of refinancing your property, you should at a minimum call your private banker to purchase a hedge instrument to protect you against rising interest rates.
Anything short of that and you are simply gambling.
Dan E. Gorczycki is a managing director at Savills LLC
This article was republished with permission from National Real Estate Investor.