Throughout the month of March, Chatham Financial has conducted interviews with more than 60 lenders, capital markets teams, and other market participants in an effort to understand the impact of recent economic events on commercial lending markets. Many of these conversations happened on at least two occasions—once at the beginning of March as base rates declined significantly and then again in late March as credit spreads widened. The following answers to commonly asked questions summarize the results of these conversations.
How have declines in U.S. Treasury yields impacted market rate conclusions for fixed-rate debt?
During the month of March, there have been two material market shifts for commercial real estate loans. Beginning in January and into March, the 10-year U.S. Treasury yield began to decline precipitously closing at a high of 1.88% on January 2 and a low of 0.54% on March 9. Based on conversations with lenders, capital markets teams, and a review of origination data in early March, many lenders were pricing new fixed-rate loans with all-in coupon floors between 2.50% and 3.00% depending on term and property-level risk characteristics; with only best-in-class, low risk investments receiving the lowest coupon floors. However, late into the week of March 16, floors and credit spreads began to climb significantly as lenders became more concerned about the economic impact of the COVID-19 crisis. Beginning March 18 and into the last full week of the quarter, many deals with executed commitment letters are still closing with some mutually agreed delays occurring for unstabilized properties. Chatham has been made aware of a few deals that failed to close due to significantly increased pricing or the lender pulling out of the deal altogether. Many, but not all active deals with signed term sheets are being repriced with office, apartment, and industrial properties tending to hold existing pricing, and properties that may be more immediately impacted by state and local lock-downs repricing upward by 50 to 100 basis points. Outside of signed term sheets, most lenders have generally stopped providing quotes for new deals, with some lenders reporting quotes only for best borrower credit with all-in coupon floors ranging from 3.50% to 4.25% depending on property type and location.
What is the expected change in market rates from December 31, 2019?
While in early March it was expected that market rate conclusions were decreasing by as much as 60 to 80 basis points, the spread widening in late March has reversed those declines with market rates for some property types such as hotel and retail increasing from fourth quarter. As of March 24, 2020, and based on our market research, market rate conclusions will remain flat quarter-over-quarter for office, industrial, and apartment loans with an applied market rate floor of 3.50%. This means that some loans that had historically received low market rate conclusions may result in an increase to the market rate floor. Others that had historically been above the floor will result in no change quarter-over-quarter. Retail properties not materially impacted by COVID-19 closures, such as many grocery anchored centers, will receive a market rate floor of 3.75%. Retail that has been impacted by COVID-19 closures, as indicated by late March adjustments in property values, will receive higher market rate conclusions with a floor of 4.00%. Other property types that have been materially impacted by recent events may receive even higher market rate conclusions including student housing and hotel.
How have the private placement markets been impacted by recent events?
Similar to the markets for secured real estate loans, spreads for private placements have widened. Based on conversations with market participants and recently marketed and closed transactions, we are concluding to market rates for 10-year private placements at 3.20% to 3.40% for NAIC 1 rated issuers and 3.40% to 3.60% for NAIC 2 rated issuers, depending on borrower credit and portfolio fundamentals. We will also apply minor adjustments for private placements with different term lengths.
How are lenders adjusting floating-rate spreads?
1-month LIBOR decreased by 81 basis points month-over-month from 1.67% as of February 6 to 0.86% as of March 6, but has since risen slightly to 0.94% as of March 23. Based on conversations with borrowers and lenders of senior floating-rate loans, spreads have widened 30 basis points on average for all property types quarter-over-quarter. This is an increase of 15 basis points from early March indications. Similar to our fixed-rate mortgage conclusions, market spreads for floating-rate loans may be further adjusted based on the impact of COVID-19 closures on property values.
How are LIBOR floors factored into the debt fair values for borrowers?
LIBOR floors in loans from debt funds and other non-bank bridge lenders have been a common structural feature as many of these lenders are focused on ensuring an all-in minimum yield. Over the past few years, as LIBOR fell and this space became increasingly competitive, we’ve seen these floor levels come in, with floor levels approaching zero. Over the past few weeks, though, as funding costs for these lenders have gone up, we’ve seen these lenders push for higher floor levels again, though in some cases they’ve been willing to trade high spreads for higher floors, resulting in similar all-in rates, and potentially mitigated impact on debt fair values for these loans. However, conditions in late March have led to significant widening of spreads for repo lines as well as banks instituting their own LIBOR floors. As a result, we increased transitional loan spreads by 15 basis points despite the offsetting changes in LIBOR floors.
How are changes in property values impacting debt valuation conclusions?
Based on conversions with investment managers, including most members of NCREIF’s Valuation Committee, property values are generally remaining unchanged for first quarter financials. The exceptions to this are hotels, student housing, unstabilized properties, properties under construction, and some retail properties. Other than hotels, which are receiving downward pricing adjustments, the changes to these properties appear to be limited to cash flow adjustments such as increased credit loss and vacancy assumptions, decreased market rent growth projections, and in some cases the addition of three to six months of rent concessions. While most agree that the second quarter could bring additional depreciation in real estate values, it is still unclear if/how the current economic crisis will impact cap and discount rates for performing real estate. As a result, it is important to align debt valuation conclusions with corresponding changes in property values so as not to create a dislocation in net asset value calculations. Therefore, changes in property values are carefully considered in the determination of how to adjust market rate conclusions for the purpose of marking debt to market for borrowers.
What is the impact on debt valuation conclusions if U.S. Treasury yields continue to fall or drop below 0.00%?
On Tuesday, March 3, the U.S. 10-year Treasury yield dropped below 1.00% following the Federal Reserve’s emergency 50 basis point interest rate cut. Subsequent to that, the 10-year yield ended the next three business days at 1.02%, 0.92%, and then 0.74% on Friday, March 5. Early in the day on Monday, March 9, the 10-year yield dropped to a low of 0.32% intra-day as markets continued to assess the impact of both the COVID-19 outbreak and the more recent collapse of oil prices; and in response, investors continued to pile into haven assets. On Sunday, March 15, the Fed cut the target range for the Fed Funds rates to 0-25 basis points and announced that it would purchase a minimum of $700 billion in Treasury bonds and MBS in the coming months. Additional actions by the Fed since that rate cut have included the announcement of the Commercial Paper Funding Facility (CPFF), the establishment of the Primary Dealer Credit Facility (PDCF), the announcement of the Money Market Fund Liquidity Facility (MMLF), expanding its dollar liquidity facilities from five to nine foreign central banks, expanding its bond buying program to include Agency MBS, and announcing three new lending facilities designed to provide up to $300 billion in additional liquidity to consumer and corporate credit markets through the Term Asset-Based Securities Lending Facility (TALF). These quantitative easing programs help to keep yields positive, however all tools (including negative rates) remain open to the Federal Reserve and there are scenarios where they may choose to use them in concert.
Should yields decrease further, or even reach or fall below 0%, market rate conclusions for the purpose of valuing debt will continue to be based on lender activity and conversations, where it is likely that coupon floors will persist.
How are swap valuations impacted by this market move?
Consistent with volatility in the Treasury markets, derivative products have also experienced material swings in value over the course of the past month. The 10-year monthly money swap rate has ranged between 0.60% and 0.70% over the last several days, representing a historical low and a precipitous drop from 1.75% at the start of the year. With swap rates at unprecedented levels, swap liabilities for existing hedges are likely top of mind. The dollar impact from recent market volatility will depend heavily on the structure of the hedge (e.g., notional, term, locked swap rate, etc.). Chatham performs daily valuations for all hedges housed on our platform, so please reach out if you’d like to receive an updated set of swap valuations using current market rates. Additionally, if you are in the process of exiting an investment or considering adjusting your hedges, we can help you analyze breakage and/or the potential impacts of layering additional hedges in this market as rates continue to move.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal/notices/.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved. 20-0086
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