There are differences in how short-term money (lent on a term of less than 10 years, but most commonly between 3 and 7 years) is priced versus long-term money (lent on a term longer than 10 years). When lenders offer a fixed rate for 5 years versus 15 or 20 years, the cost of funds to the lender are different. What factors go into pricing the costs of these funds, and how does this ultimately affect the rates offered on commercial real estate debt? In this article, we’ll provide a high-level overview of short-term versus long-term money, how’s it’s priced, and what influences the costs.
In general, commercial banks are the most common short-term lenders for commercial real estate loans; within this sphere, there are distinct differences between local, regional and national banks. Some federal regulations are different for smaller community commercial banks versus larger commercial banks, which can have an impact on their respective cost of funds and the types of loans each can make. A given bank’s costs of funds are an import factor to understand why some short-term lenders are more competitive on the rates.
Short-term money is defined here as a term of less than 10 years, but is typically 3-7 years. How does the Federal Reserve influence the cost of funds? The Federal Reserve, also known as the central bank, sets monetary policies and can therefore directly impact the cost of funds to commercial banks. In simple terms, banks make money by charging a spread on top of their cost of funds. Cost of funds are determined by the combination of the number of deposits on hand, administrative overhead, their existing loan portfolio and the discount rate. When any one of these factors change, it impacts the commercial bank’s cost of funds: when their costs increase, the borrower ultimately pays more for an interest rate. So, when the central bank increase the discount rate, it impacts short-term rates for any new loan being considered. It is important to know which banks have room to be the most competitive when regulators change policies and the discount rate.
When you hear that the Federal Reserve is going to increase the rates by 25 basis points, that's going to impact the pricing on any commercial real estate loan currently being negotiated. If rates change while you are in the originating process before your rate is locked, you can expect your rate to change along with it.
Long-term money is generally defined as anything with a term of 10 years or longer. Most lenders that lend on long money are going to look to the bond market for pricing guidelines. In general, the 10-year treasury is the most common benchmark for determining costs of funds for commercial real estate loans. Whatever is influencing yields to fluctuate in the bond market will directly influence long-term interest rates.
Unlike short-term rates controlled by Central Bank, where they can decide to increase rates and then do so immediately, bonds are influenced very differently by the open market. The Federal Reserve does have influence over the long-term rates, but there is much more of lag between their actions and the market’s response to their actions. U.S. Treasuries bonds are government debt issued by the Federal Reserve with a promise from the government to pay back at maturity; because these bonds are secured by the United States Government, they are perceived by investors as low-risk investments. Therefore, as investors evaluate risk and return, the treasury indexes are considered the cost. The investor (lender) will then add a spread on top of the corresponding index to determine the interest rate the borrower pays. For example, if the loan has term of 10 years, then they would look to the current 10-year treasury index rate and add a spread on top of it to come up with the interest rate. The index rates fluctuate based upon market conditions; however, spreads that the lenders charge are based upon competition between other lenders for quality assets to invest mortgages in.
So, how does that affect long-term commercial mortgages? Let’s look at an example: imagine that the 10-year treasury is 2.5% and the lender is looking for a 200 basis points (2%) spread over the corresponding index. If there's a lot of money pouring into the bond market when you're getting ready to lock your rate and the 10-year treasury drops to 2.3%, your loan interest rate just decreased by 20 basis points (.20%).
Choosing Between Long-Term & Short-Term
So how do you choose between long-term and short-term rates? The answer depends on your exit strategy. If it is a short-term hold, stay short to avoid unnecessary costs like prepayment penalties. However, if it is a long-term hold, going long can take the risk out of rising rates and avoids repeatedly incurring closing costs at each new financing.
In the recent past, we have seen investors financing long-term commercial real estate assets with short-term money. Often it is because banks can offer higher loan-to-value ratios, up to 80%, and extremely inexpensive short-term money. Long-term rates have also been historically competitive, but there has been enough of a difference between long-term debt and short-term debt that there is an incentive for commercial real estate investors to stay short. Many commercial real estate investors have not been concerned with rising interest rates as the Central Bank’s policies have been aimed at low rates until recently: currently, the Central Bank has begun shifting their policies to higher short-term rates and are beginning discussions on when to start selling the bonds they hold. As they do sell, the bond index will increase, causing long-term rates to increase on new loans.