By Paul Rahimian, Founder & CEO, Parkview Financial
Last month, a friend of mine asked me a seemingly simple question about capital markets: “Did they change overnight, or is it me? What did I miss?” Like many of us, he was feeling some optimism after the Fed rate cut on September 18th. However, the reality is that market movements—namely, the 10-year (and other) treasuries—began earlier in anticipation of the rate cut.
When treasuries move, regardless of their maturity, they directly impact lending and refinancing options, especially on commercial loans. Home mortgage loan rates are also dropped quickly, but commercial loan rates are important to note because most lenders are stuck with high treasuries that limit loan proceeds.
The wall of maturities in the commercial real estate space is continually expanding. However, if there is even a possibility of refinancing some commercial loans, the real estate industry can collectively breathe a sigh of relief. To understand how this works, let’s look at the following:
A lender will examine an asset’s risk profile and how likely a borrower will pay off the lender at maturity. Part of how they determine this is through the debt service coverage ratio (DSCR). The DSCR divides the asset’s net income by the amount of cash needed to pay the interest and principal on the debt. As interest rates go up, the denominator in this formula goes up. Unless we expect considerable increases in the net income (which would mean higher rents), the interest rate payments can skyrocket – limiting the take out loan upon maturity. This jump is what many real estate borrowers have experienced over the last two years.
On the other hand, the treasuries begin to drop when the Fed signals a future rate cut (hopefully, there will be more to come). On reflection, the 10-year treasury was close to 5% in October 2023. That same index was below 3.75% in September 2024 (note: at the time of this publication, rates may have started to creep up again – a sign that anything can happen – and quickly). The change from 5% to under 4% is a significant drop, and the above formula can quickly create more loan proceeds for borrowers.
Essentially, more proceeds mean more dollars are being lent, and more money is circulating in capital markets. After stagnating for a long time—about two years but what felt like longer in the real estate industry—loan proceeds are finally increasing, rates are decreasing, and loans are closing.
Capital markets can move quickly with a rate drop (and the anticipation of more). I believe that my friend who had asked about capital markets and what he missed did so, because he felt that movement in the marketplace but couldn’t quite place the source.
Paul Rahimian, CEO, Parkview Financial
September 27, 2024
