Investors need to consider other scenarios that could show a little bit more volatility.
Andrew Thornfeldt, managing director at Chatham Financial, thinks investors are over-reliant on the forward curve when trying to understand where interest rates are heading.
“Over a 10-year period, since the creation of LIBOR, it’s never been more advantageous to enter into a fixed rate swap versus floating on LIBOR,” Thornfeldt says.
Over a five-year period, it has only been more advantageous to go fixed rate 11% of the time, according to Thornfedt. “So we’re looking at a pretty extreme benefit to going floating over fixed at least as it relates to swaps versus LIBOR over longer periods of time,” he says.
Typically, institutional real estate investors use interest rate projections in their overall leveraged buyout or discounted cash flow model. “That is a very common assumption,” Thornfeldt says. “A huge percentage of the institutional commercial real estate world ends up using that as a key input into their acquisition models, their debt models or whatever DCF [discounted cash flow] model they’re using to make investment decisions.”
Thornfeldt urges investors to consider other scenarios that could show a little bit more volatility. He thinks they should look at a period where rates dropped the most and how that impacts cash-on-cash returns, their levered IRR and DCF model.
“Then, of course, there are some more nuanced scenarios where you say, ‘If I was to look at a five-year investment horizon and I wanted to shock the system for a two or three-year period, what’s the most volatile interest rate environment for two or three years? Then assume some stability after that?,” he says. “How does that impact my levered IRR and my levered returns or cash on cash?”
Those are some of the environments that investors should consider.
“Depending on your risk tolerance, you may or may not want to take into consideration the most extreme examples that have happened historically,” Thornfeldt says. “It would be imprudent not at least to consider exploring outcomes that have happened historically within the timeframe you’re now in.”
While the forward yield curve has value, Thornfeldt says it’s necessary to evaluate several other environments and a wide range of scenarios. “What you evaluate should likely be tied to your risk tolerances and project-specific dynamics,” he says.
Thornfeldt proposes evaluating a wide range of potential future interest rate environments before making investment decisions. Some typical environments to explore include historic rising and falling rate environments, hawkish and dovish Fed policy environments and forward curve shocks.
Thornfeldt thinks investors should look back in time to see how interest rates performed over their hold time.
“Whatever my analysis period is, what’s the timeframe where interest rates went up the most over that time period,” Thornfeldt says. “Why don’t they apply that historic interest rate environment over their analysis period, whether that’s the next two, three, five or 10 years.”