In commercial real estate (CRE), the forward curve for a market index (like SOFR) is the representation of the relationship between the price of financial contracts and the time to maturity of those contracts. The SOFR forward curve is derived by observing where contracts like SOFR futures and SOFR swap rates trade. These forward curves are used to price SOFR-based derivatives including swaps, interest rate caps, and floors, and they are often used by borrowers for underwriting and budgeting.
We sat down with Shawn Murphy, Director at Thirty Capital Financial, to gain a greater understanding of using the forward curve to forecast and identify optimal times to transact.
What are some strategies for mitigating risks associated with forward rate variability in CRE investments?
Forward rates drive the cost of hedging against adverse rate movement. Changes in the forward curve, particularly as it moves higher, can increase the need for a borrower to raise capital to extend their hedge at rates that are under their capital agreements.
There are several products that are available to investors to hedge against upward rate movement. Forward starting caps and swaps allow investors to avoid trading in some elevated spot rate environments, like what we are currently in. This allows borrowers to take advantage of the inverted yield curve that we’re seeing today.
What tools would you recommend for improving the precision of forward rate forecasts in CRE transactions?
Forecasting forward rates is not a precise science. They do not, in any way, represent where rates will be at a particular point in time. In reality, they represent investors’ demand on any particular day to invest capital. The only way to remove the risk of actual rates deviating from the forward curve is to hedge against those rate movements. The way to improve precision of forward rates is by locking those rates in today. By doing this, a borrower can budget for a known cost, versus trying to guess where rates might move in the future. For help with locking in rates and identifying an optimal time to transact, reach out to our team.
How can forward rate analysis be leveraged to pinpoint the most advantageous timing for buying or selling commercial properties?
Real estate investment decisions should not be made based on forward rates. Forward rates should instead be used to determine the cost of capital that can be fixed via a hedge.
In Q1 of 2024, the two-year rates increased by 50 basis points because the forward curve removed two Fed cuts. Anyone that was using the forward curve a month ago to make decisions today just lost 50 basis points in their projections, meaning that the cost to refinance their debt increased. Had they locked those forward rates a month ago or capped them off, they could have used them to more effectively drive their decisions today.
What guidance can you offer for interpreting forward rate trends and translating them into actionable decisions?
If you’re using forward rate analysis to make future decisions, you need to make sure that you’re updating your models every day. Your strategy will then likely need to adjust every day based on how things are moving within the market.
Otherwise, reach out to our team for help interpreting the rate curve or locking in a particular position today.
What issues may arise if you transact at the wrong time?
Timing the market is essentially impossible. As borrowers borrow money over time, they fix and cap the rate over that time as well. By doing this, they are always in the market by using a dollar-cost average approach, which is a systematic approach to hedging that will be more favorable than trying to time the market. If you always transact at market rates, over time you will trade in higher and lower environments.
There are also times in which investors need to roll their required hedges forward at rates that were established in a much lower rate environment. Investors that either do not hedge or enter a shorter duration of that hedge need to understand the potential risks of the forward curve being wrong when it comes to making real estate decisions.
About Thirty Capital Financial
Thirty Capital Financial is a leading service provider to the commercial real estate industry. Our team of advisors have spent decades providing solutions for defeasance, interest rate hedging, and debt management. With our personalized approach, we provide you with the tools, solutions, and strategies to confidently manage debt while supporting the growth of your company. Contact us today to speak with an expert defeasance consultant!
