I hate jumping on the Coronavirus bandwagon of content, but like it or not, it is having a real effect on our global economy and is causing a lot of uncertainty in the financial markets. This uncertainty is impacting the interest rates available on commercial real estate debt.

It’s really hard to say, nor is the point here to talk about what the Coronavirus situation really means to our economy long term. It is too early to really know.

What we do know is toilet paper is hard to come by right now! There is no indication toilet paper manufacturing plants will become inoperable, but the buzz is that there won’t be enough, so everyone rushes out to buy all they can.

Retailers have and I’m sure will, continue to raise prices on this hot commodity because demand is so high and there are shortages. People still want it so they will pay more.

This micro economic situation can teach us a thing or two about what is happening in the debt markets for multifamily real estate.

As we examine how the capital markets are reacting to COVID-19, we see how basic economic laws are playing out there as well. The more our community knows, and can apply that knowledge effectively, the more profitable we all will be.

My goal is to have clients that are wildly successful.

Let’s look at some of the facts. As the Coronavirus scare gained momentum, the capital markets were quick to react. Investors began fleeing the stock market as has been evidenced by significant selloffs there. Many of those investors moved into bonds because there is more certainty in bonds – especially the US Treasuries.

We know from basic economics that when demand goes up, and there is a fixed supply, the price will also increase. This is what happened with bonds recently. As the price goes up on bonds, the yield (interest rate investors receive) goes down. That is why the yield on the US Treasuries has decreased so rapidly over the last couple weeks.

Interest rates for commercial real estate loans – especially Agency, HUD, CMBS, and Insurance Companies – are tied to the US Treasuries.

As Treasury rates go down, interest rates should also go down. Or so we hope. It isn’t that linear though. And that is simply because those economic laws of Supply and Demand are still in effect.

Here’s what happens – commercial real estate investors see these treasury rates decrease, get excited, and send in an application to refinance their property.

Everyone wants to “time” the market and when we see the US Treasuries go down, we feel like “now is our chance!” Well – not so fast. The market for debt quickly becomes flooded with loan requests. But there is limited supply of either time (capacity for the lender to process these applications) or a limited supply of actual capital (for example Fannie & Freddie have annual allocations they aren’t allowed to exceed).

Because the demand has increased and there is limited supply, how can market throttle that new demand?

It’s simple – pricing goes up.

Prices go up when lenders put in place rate floors and/or loan spreads widen.

We’ve seen is Treasury rates dropped quickly. There was a deluge of loan applications, thus really testing the capacity of the market, and that volume wasn’t sustainable, so rates have crept back up to offset the demand.

Rates are fantastically low right now, but they aren’t as low as they would be had the spreads between the US Treasuries and the note rate stayed the same. It’s quite interesting given the 10-year US Treasury has basically been cut in half over the last couple of weeks.

To try and keep a technical conversation simple, think in terms of supply and demand. Those are concepts most of us are familiar with. The demand for loans has increased, supply hasn’t changed, so loan pricing elements must change in order to accommodate. Just like with toilet paper.

So, what does this mean? What is the right strategic approach today and over the next couple of months? That really can’t be answered unless you know your holding period of your asset(s). I believe that is the most important consideration right now because marrying the debt term and pre-pay structure will ultimately be more important than trying to get the absolute lowest rate.

Short-Term Hold

One of the most important considerations when choosing your loan terms is how long you plan on holding the property. I was recently quoting a 10-year Fannie Mae loan for an acquisition because the rate was so attractive. The buyer shared they felt like they had a 50/50 chance of selling the property within 3 years.

When we looked at the pre-payment penalty for selling in 3 years, it made more sense to choose a higher rate Freddie Mac loan with a step-down prepayment penalty rather than yield maintenance. Paying a little more now in interest rate will save them thousands of dollars should they decided to sell.

Long-Term Hold

Now is a fantastic time to remove a lot of uncertainty from an uncertain economic environment with low interest rate long term debt. If your strategy is to hold for 5+ years, now is a great opportunity to lock in cheap debt for a long time that will not only provide more cash flow but prevent you from having to refinance or restructure in an economic downturn.

Right now, the capital markets are alive and well. We haven’t seen any material slow down or unwillingness from capital providers to curtail their offerings and thus debt availability yet. There will be some significant economic ramifications to the Coronavirus, which means these sources of capital may change their tune and remove some of the liquidity from the market. But as of now, most everything remains open for business.

If this COVID-19 situation results in a long term economic slow-down, having to refinance in a recessionary period with limited options could potentially end poorly for highly leveraged investors. That is why 2020 will be an important year to secure good debt to ride out the storm that is brewing. Leapfrogging a recession with long term debt in place removes one of the biggest risks to losing a property. That risk being having to refinance when values are down, and debt financing is in short supply.

Penultimate thought – pulling cash out with non-recourse debt – could provide capital to invest opportunistically should property values come down.

Most importantly – stay safe and be well during this difficult time. We will be okay and likely better off.

Smooth waters don’t make for strong sailors!