To Fix or Not To Fix, That Is the Question

A few months ago, we started the process to refinance a few of our variable-rate loans into 7-year, fixed-rate loans.? The fixed rates are based on the 7-year Treasury plus a spread which has been in the range of 1.50%. Here is a chart of the 7-year Treasury that goes through September 16th.

One can see our enthusiasm for refinancing as rates dropped by approximately 1% from their previous peak. Our timing was quite good for one of the recently closed loans, as we locked our rate very close to the bottom.

Applying the information from this chart to our refinance analysis, if we use the forward curve as gospel, then we can assume the index will settle out in the 3.85% range. The average spread in our floating rate portfolio is approximately 1.70% which would have our floaters bottoming out at approximately 5.55%. For the loan referenced above, the spread was 1.44% so the bottom would be 5.29%, still higher than the fixed rate alternative. Add to this that the loan was maturing in May 2025, this made the refinance decision a no brainer.

I mentioned that we had a few properties that we put under application to refinance based on the math as described above being compelling. Unfortunately, as it’s been said, “What God giveth, he can taketh away.” This is what happened to the 7-year Treasury yield since bottoming on September 16th.

The math became more compelling to refinance with the 7-year Treasury in the 3.75% range. The rate we were paying on our floating rate loan was approximately 6.00% while the fixed rate we locked in was 4.81%. This allowed us to get an immediate benefit from a lower rate and eliminate the need to purchase interest rate caps. We do give up prepayment flexibility by converting to a fixed rate loan as well as the potential to benefit from rates going lower than the fixed rate. We felt like the tradeoff was worth it.

Here is a chart of the forward curve for SOFR, which is the index our variable loans are tied to. The large circles represent the Federal Reserve’s median forecast for the Federal Funds Rate. One can see that the market thinks the Fed is too aggressive in terms of future rate cuts.?

Rates have shot back up by approximately 0.8% to 4.34% as of this writing. This dramatically changed the refinance equation. For example, one of the loans we were planning on refinancing has a spread over SOFR of 1.96%. The current fixed rate available is approximately 5.85%. We are currently paying 6.54%. The market is currently pricing in a 0.25% rate cut at the Fed’s December meeting which would bring our rate down to 6.29%, which is still higher than the fixed rate loan. This means that we have to continue to place a high value on prepayment flexibility and the potential for rates to go lower than the fixed rate equivalent.?

If we use the forward curve’s long-term rate of approximately 3.85% as the future SOFR rate, then this would translate into a future rate of 5.81%, which is very close to the current fixed rate alternative of 5.85%. So right now if we do nothing this means we are willing to pay a premium for prepayment flexibility, which not only allows us to sell with less cost if we choose to, but to also enable us to stay flexible in the event long-term rates come down again. And while getting the cap purchase off our back has value, too, we have more than enough money in our rate cap impound account to allow us to purchase two, two-year caps which will cover us for another five years as our current cap expires a year from now. This is a long way of saying that we would prefer to stay floating right now in the hopes of long-term rates coming down again.

So what are the prospects of this happening? Jay Powell is already backing off of his more dovish stance of moving forward with rate cuts as he has cited the strength of the economy as his reason why.

With that being said there are some indications the U.S. economy, and more so the global economy, moderating, or being far from overheating. I’m a fan of Evercore’s research and the charts they produce. Here are some that were released on Friday that show this trend.

The Fed has rather quietly tightened its balance sheet after expanding it massively in the wake of Covid. The balance sheet has dropped $2 trillion from its peak, but is still up $3 trillion from its pre-Covid levels.

From a technical perspective, we are at a very interesting and critical juncture in terms of interest rates. Here is the chart of the 7-Year Treasury going back to October 2022.

One can see that a downtrend that started in November 2022 through May 2023 was broken after the rate breached 4.24% and moved up to 5.00%. Since that time we have had lower highs and lower lows which is a positive for rates. The previous peak was on July 1 when the 7-year hit 4.45%. This is the rate I’m hyper-focused on as if we breach that then we could be headed back to 5.00%. The most recent high was 4.38% on November 15th and as of this writing has come down to 4.34%.?

One more datapoint. Since the Fed started embarking on its rate hike cycle in April 2022, the 7-year hit its first peak of 4.36% in October 2022. If we use this as the beginning rate for the new Fed non-Long Emergency era (something I’ve written about before), the average 7-year rate since then has been 4.06%. This is another datapoint that makes me think the trend might be a bit lower and not converting continues to make sense. It also reinforces to me that the overall equilibrium range is 3.75% to 4.25% such that when the rate drops below 3.75% we should position ourselves to lock rates for those loans in a position to do so.

When I put this all together I’m in the camp to hold off converting to fixed until rates drop back down to 3.75% or lower as this will put the fixed rate at approximately 5.25%. And while waiting may be a hope strategy, I feel like it makes sense from a technical perspective and from a fundamental one as the Evercore data suggests a softening economy via their sales survey and moderating employment costs.

I will periodically report back on the decisions we make regarding future conversions of floaters to fixed-rate loans.