It’s no longer if but when and for how long the Fed will increase interest rates in order to help curb inflation. For years, economists had been predicting interest rate hikes only to be left wondering when their predictions would finally be realized. Each year, there seemed to be the inevitable rise in rates; however, each year would pass and rates either stayed the same or decreased. At a near zero rate a few years ago, one could only surmise that rates would have to go up….someday. Well, that someday looks like it has arrived.
Typically, the Fed uses a rate hike to curb economic growth; however, the US economy is not currently in need of a slowdown. Unfortunately, recent inflation reports announced an increase in the CPI by 8.5%; however, energy prices have not been accounted for in this figure, and real inflation is over 10%. The Fed’s policies of limiting energy production in the US as well as out of control spending seem to be the culprit. It appears that the Fed will try and curb inflation by increasing interest rates; this may cause stagflation and push the US into a recession. The Fed announced its first increase [.25%] in interest rates and has made known that this is the first of many to be expected. Increases of .5% increments are most likely to experienced.
Sponsors of real estate syndications, primarily in the mortgage debt area, should expect their investors to ask how rising interest rates will affect their current investment as well as what to expect on the horizon. Challenging times may lie ahead for those sponsors who hold long term, low, fixed interest rate loans in their portfolio, as borrowers who have locked in lower rates tend not to refinance and these loans may only get paid off upon a sale of the real estate. New investment money, however, should be able to get placed in higher rate loans. The question becomes how easy will it be for these sponsors to raise new investor capital. The good news for these sponsors is that all investments are based on alternatives/opportunity costs, and, until bank rates to depositors increase significantly, many investors will look to alternative investments. In areas of the country where there is ample investor capital, competition has kept interest rates low for borrowers. Eventually, as interest rates increase, investors will demand a higher return on their money. This will, in turn, be passed onto borrowers in the form of higher rate loans.
When residential interest rates were in the 2.5% - 3% range from conventional lenders, alternative lenders in competitive markets, such as California, were charging their borrowers as low as 6% - 8.5%. Although conventional rates have recently risen to 4.5% - 5%, private lenders have not substantially increased their rates due to competition between lenders. There is still a lot of capital chasing loans to invest in. A common complaint among private lenders is that they get paid off too early on loans, and their money is sitting idle in a low interest rate account awaiting the next deal. Many investors have broadened their risk tolerance to have their money working for them. Lenders who, normally, would not invest in loans unless the LTV was below 65% have been forced to look at loans at 70% LTV and above. Where just a couple of years ago, individual investors could easily attain 8% on private loans at 65% LTV, they are now needing to view 70% LTV or higher loans to receive, on average, less than 8%. This has frustrated the individual investors who long for years gone by when private capital was not as prevalent in the marketplace. Unfortunately for these investors, large hedge Funds and other Wall Street type investors have entered the market and competitive forces have driven down interest rates for all investors.
For those sponsors who make short term loans, they should be in a better situation as their loans will eventually come due, and their borrowers will be forced to either pay off the loans or accept a higher rate if the sponsor chooses to re-write the loan. They will not get caught up in an increasing rate market as they can adjust quickly. As long as there is a fairly large delta between what investors can achieve in relatively risk-free investments, such as bank deposits, sponsors should be able to still raise money. The question becomes, “How large does that delta have to be in order to attract those investors?” In past years, the difference between what investors could expect from bank deposits and alternative investments in the lending arena was about 5%. This delta shrank to about 3.5% due to competition in the private lending market as well as a strong economy, as investors were willing to accept a lower rate when the economy is strong as well as the real estate market. Currently, the real estate market is still strong, but confidence in the economy is wavering. Eventually, investors will demand a higher delta as they perceive there is more risk to their capital.
Another variable that comes into play is when banks get skittish and hold back on lending. During a strong economy [and real estate market], banks tend to loosen their underwriting as much as they can and still stay within Federal guidelines; however, when the economy contracts, banks become more concerned about the ill effects of potentially troubled loans as they have to raise their reserve requirements and this hampers their ability to lend; at those times, banks will be very choosy and only lend to the most qualified of borrowers. The borrowers who normally could qualify for bank financing then find themselves having to go to alternative lending sources and this brings opportunity to the alternative lender. During these times, we should see a pick up in loan volume by the alternative lenders. This can also have the effect of driving interest rates higher as the demand for money [borrowing] starts to outweigh the supply of funds available, and the alternative lender should be able to command a higher rate on lendable funds. Many “hard money” lenders saw an increase in business during various economic instabilities in the lending arena. The S&L crisis in the early 1990s, the Dot Bomb of the early 2000s, and just after The Great Recession of the late 2000s provided quite a boon for the astute private lenders.
All in all, most alternative lending sponsors should have an increase in business over the next few years provided they keep prudent underwriting practices.
Edward Brown is in the Investor Relations department at Pacific Private Money and is host of the long running radio show, The Best of Investing. He has multiple published works and has appeared on CNN and has also served as chairman of the Shareholder Equity Committee protecting 29,000 shareholders in a $500 million REIT. Edward was also a recipient of a prestigious MBA Tax Award."
