Short-Term Real Estate Debt Financing vs. Long-Term Debt
The banking industry plays a crucial role in facilitating economic growth and stability throughout the United States. However, regional banking issues have recently emerged as a significant concern as rising short-term interest rates (most notably construction financing and short-term debt instruments), have increased significantly and have impacted many borrowers seeking construction, bridge, or short-term lending structures. This article explores the impact of this issue and examines the trade-offs associated with different debt durations in the current banking landscape.
Short-Term vs. Long-Term Debt
Short-term indexes such as the Secured Overnight Financing Rate (SOFR) and the Prime Rate (Prime) differ in several ways as compared to long-term indexes such as the 5-year and 10- year Swap Rate or Treasury bond indices.
Short-term indexes are generally used for shorter-duration financial transactions, construction loans, bridge loans and variable rate financing instruments. Economic conditions and monetary policies often influence how these indices are priced (either via Fed policy and/or economic factors such as inflation). As the Federal Reserve changes its monetary policy; increasing or decreasing the Discount Rate (the rate of which banks loan from each other), the change in rates loosens or tightens money flows and interest rates. As rates increase, the Prime and SOFR indices follow suit, and as these indices increase, borrowers pay more interest for these variable rate products.
Longer-term indexes, such as Treasury yields and SWAP Rate are influenced by broader economic factors, such as U.S Treasury Bond supply and demand, in addition to other factors such as economic growth and market expectations. Long-term indices provide benchmarks for fixed-rate mortgages and other financial instruments with extended repayment periods and are typically five years or longer in duration.
Short-term rates are currently higher due to short-term capital market risk, Federal Reserve monetary policy decisions and other market factors such as inflation expectations.
Short-term debt instruments are defined as loans or financing options with less than three to five years in maturity; most notably construction loans which range between 12 to 48 months. Regional banks frequently use short-term debt to address immediate funding needs, such as maintaining liquidity, financing day-to-day operations, or managing short-term obligations. Pricing of short-term debt is entirely market driven, and as of today, are priced considerably higher than longer term financing options due to the Yield Curve (where bond yields are cheaper than SOFR and Prime). Short-term borrowing does offer flexible prepayment options compared to long-term debt structures and can be useful for clients who are adding considerable value to their project via leasing and/or pre-sale. The risk of short-term borrowing does include frequent rollover costs (refinancing the debt upon maturity) which can lead to increased borrowing costs.
Short-term financing encompasses a range of choices, each serving specific purposes. Among these options are interest only loans, which involve repayment structures without periodic principal payments. Borrowers make interest payments throughout the loan term, with the principal amount due in a lump sum at maturity. Because these loans are short in duration, often repaid within 12 to 48 months, borrowers need to plan for an exit strategy; either refinancing the loan with the lender or another source for a longer-term option, selling the asset or paying off the debt entirely.
The problem clients face today are predominately underwriting issues. Because short-term rates have moved up so quickly over the past 12 months (500 basis points, soon to be 525 basis points), new projects (such as new builds, construction or short-term acquisitions) are not “penciling out” to where the risk of building and stabilizing an asset is worth the higher interest rate payments and additional client equity capital to make the deal work. Until we see the Federal Reserve pivot and reverse course, which will rely on wage growth metrics, unemployment and inflation; borrowers will have to adjust their capital stack (equity and debt) expectations.
Long-term financing is usually defined as a debt instrument longer than 48 months. This could encompass various financial obligations, such as business loans with repayment periods of five years, lines of credit that need to be settled within a certain period, or mortgages that can have a duration of up to 30 years. Typically, long-term debt serves to finance stabilized assets for purchases and or securing long term cash flow objectives. Long-term debt instruments are typically amortized, where the borrower is paying both principal and interest payments, lowering the principal balance down over time. Currently, due to the inverted Treasury yield curve, longer-term financing instruments are priced less than shorter-term rates. However, the “spread” over the index (the lenders rate of risk return pricing) varies depending on the creditworthiness of the transaction and its borrower. Currently, borrowers can borrow at a 10-year fixed rate between 5.80% to 6.75% as compared to a 12-to-18-month variable rate or construction loan in the 7.75% to 8.75% range. The good news regarding long-term debt financing, Regional Bank typically do not lend long term, their balance sheet does not allow them to secure those types of instruments unless they were to sell the note in the open market. Typically, life insurance companies, debt funds, money center banks, CMBS shops and Credit Unions make up most of the long-term financing debt market, and there are many viable options.
Regional Banking Issues
California regulators took action on March 10th, 2023, to close Silicon Valley Bank (SVB), resulting in its subsequent takeover by the Federal Deposit Insurance Corporation (FDIC). This development marked the second-largest bank failure in the history of the U.S., leaving approximately $209 billion worth of asset deposits in a state of uncertainty. Following closely, on Sunday, March 13th, New York regulators announced the closure of Signature Bank, which ranked as the third-largest failure in U.S. banking history. As per the New York State Department of Financial Services, the FDIC assumed control of assets worth $110.36 billion and deposits totaling $88.59 billion as of the end of 2022. The revelation of these failures has had a notable impact on the markets this week, evoking memories of the sequence of events that led to the collapse of AIG and Lehman Brothers in 2008.
The failure of SVB has resulted in a significant loss of tech clients for smaller banks. Western Alliance, an Arizona bank heavily impacted by this, experienced over a 40% decrease in deposits from tech clients. However, according to The New York Times, this decrease was less than expected. Overall, the bank’s deposits fell by 11% in the first quarter due to the negative reputation associated with SVB’s failure. However, deposits stabilized and began to grow again in the first weeks of April. Pacific Western Bank is selling off major portions of their loan portfolio and has ceased real estate lending as well as Zions Bank, leading to fewer real estate lenders in the marketplace.
The financing landscape is always evolving, and commercial real estate does experience “cycles.” It’s important to stay informed regarding which lending sources are “in” the market and who are “not.” This is where Matthews™ Capital Markets earns its value. We are in the market every day, for all asset classes and for all financing structure types. Having an experience and knowledge mortgage banker/advisor can make or break your next real estate transaction. From ground up construction, to acquisition bridge financing, mezzanine financing, preferred equity placement, to long term non-recourse life company or debt fund financing, we have the expertise to educate and execute on your next deal or portfolio.