In response to the economic unrest caused by the COVID-19 pandemic, the Federal Reserve (the “Fed”) announced a series of moves on March 15th aimed at supporting the financial system and economy at large.
What were some of the most relevant steps that the Federal Reserve took this week?
First, the most widely reported move was lowering the federal funds rate by 100 basis points (1%) to a 0% – .25% range. This followed the Fed’s cut of 50 basis points (.5%) last week. The federal funds rate is the target overnight lending rate that banks can charge other banks to meet required reserve balances. More importantly, this rate is used as a benchmark for other short-term interest rates and is influenced by the overall money supply, which is controlled by the Fed.
Second, given the unprecedented shut down of multiple sectors of the economy, ranging from local restaurants to resorts and air travel, the Fed has called on banks to work with borrowers suffering from temporary income losses during the pandemic.
Third, to further ensure credit is available to banks so they can offer such relief, the Fed cut the rate it charges commercial banks and other financial institutions that borrow from it directly through its discount window — called the discount rate — to .25%. However, this Fed-to-bank lifeline is almost never used by banks due to the stigma that became associated with it during the 2008 financial crisis: that it is an indicator of a bank in trouble. In anticipation of this reluctance to borrow cheap capital directly, the Fed has announced that it will revive other facilities created during the 2008 financial crisis that were more readily acceptable by banks along with increasing its own repo operations (repurchase agreements).
Fourth, the Fed announced a new quantitative easing plan that involves injecting $700 billion into the market by buying at least $500 billion in U.S. Treasuries and $200 billion in mortgage-backed securities, the ramifications of which we explain below.
Finally, the Fed provided forward guidance that they will use all available tools to keep the economy functioning through this crisis.
What does the Fed’s interest rate cut mean for interest rates on loans?
While the Fed’s rate cut will result in lower short-term interest rates, this does not mean a 1 to 1 reduction in all interest rates. To better understand this, let us first explain the two common components of an interest rate for loans secured by multifamily properties. Whether it is a fixed rate loan or a floating rate loan, the interest rate is typically comprised of an “index” and a “spread.” The index can be common interest rate indexes, such as U.S. Treasury rates or LIBOR, which can fluctuate up or down. The spread is a set amount above the index, which when added to the index, comprises the full interest rate for the loan. Therefore, when a rate is quoted as 300 basis points over LIBOR, the rate is 3% plus whatever the LIBOR rate is either at closing for a fixed rate loan, or at a predetermined day of the month for floating rate loans. As interest rates change over time, the interest for floating rate loans will change as well.
When the Fed cuts the rate to near zero, this does not mean that the index portion of a mortgage loan is reduced to the same amount, especially on existing loans. Typically, lenders will include interest rate floors, which is the minimum amount the index portion of the interest rate can be in calculating the total rate. Therefore, if a floating rate loan with a rate of 300 basis points over LIBOR includes a LIBOR floor of 100 basis points, the minimum interest rate for that loan is 4%, irrespective of how low the index rate falls as a response to the Fed’s rate cut.
One way property owners can take advantage of lower interest rates, especially for fixed rate loans, is to refinance their loans at a lower rate. However, careful consideration must be taken to ensure that this is the most prudent decision. Sometimes, costs and terms associated with a refinance can reduce the benefits of a lower interest rate. Additionally, lenders may counter the low interest rate environment by either instituting a floor for the index that is above the current rate, or by increasing the spread portion of the final interest rate.
Why do interest rates fall and what might these actions mean for the real estate market?
To understand why interest rates fall, it is helpful to understand what a mortgage-backed security is. First, a bank makes a loan that is secured by a mortgage on a property. This mortgage loan is then sold to an institution that bundles multiple loans into a pool of assets that are then “securitized.” These securitized mortgage-backed securities are then sold to the market. When the bank initially sells these mortgages, it frees up capital creating liquidity to make more loans. More readily available capital to make loans results in lower interest rates.
Additionally, when the Fed purchases these mortgage-backed securities, this provides even more liquidity to the lending industry by freeing up capital to acquire more mortgage-backed securities, and in turn further reduces interest rates. It has been reported that the Fed will purchase $200 billion of mortgage-backed securities in $40 billion intervals. The majority of these securities will be mortgages secured by single-family homes backed by Freddie Mac and Fannie Mae. The fact that the Fed is targeting residential mortgage-backed securities (RMBS) instead of commercial mortgage-backed securities (CMBS), which include mortgages secured by multifamily, office, warehouse and other commercial properties, could indicate that it views the RMBS market as needing more liquidity at this time. This correlates with what we have seen with multifamily agency lending from Freddie and Fannie, which are continuing to originate loans, even adjusting their loan-processing protocols to accept digital loan documents.
Given the current economic environment, how might multifamily investments fare compared to investments in other real estate asset classes?
Historically, multifamily assets tend to be a more stable asset class during economic downturns compared to other real estate asset classes such as retail, office or hotels. This is mostly due to multifamily investments typically having larger tenant bases than office or retail assets. Therefore, they are less impacted by individual vacancies. Also, the short-term nature of multifamily leases allows owners to be more flexible and react quicker to changing economic conditions. Moreover, no matter what the economic climate is people always need a place to live (multifamily), even if they have curtailed their shopping (retail) or have lost their jobs (office). Currently, we have seen a severe slowdown in investments and financing activity for hospitality assets as the virus has severely limited discretionary travel. Overall, multifamily real estate tends to be a more stable long-term investment.
Conclusion
We are in unprecedented times. The Fed is navigating this situation with all the tools in its inventory to provide liquidity and credit to counter the shock this pandemic is sending through our economy. The announcement of rate cuts and quantitative easing, including $200 billion for the purchase of mortgage-backed securities, along with a large stimulus package that is expected to pass through Congress, will hopefully provide the necessary available credit and liquidity. However, it is worth noting that despite our economy heading into uncharted waters, many investors are still viewing multifamily real estate as one of the more stable investments at this time.