Q4 2022: Industry Spotlight - JP Conklin

Industry Spotlight: JP Conklin

Written by Michael Becker, SPI Principal & Co-Founder & Lily Turner, Marketing Coordinator
Q4 2022 Newsletter

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JP CONKLIN, Founder & President, Pensford Financial Group & LoanBoss, Inc.

JP Conklin

is the Founder & President of Pensford Financial Group, the esteemed commercial real estate interest rate advisory firm & the equally notable commercial real estate debt management software company, LoanBoss, Inc.

JP obtained his Bachelor's degree in Economics from the University of North Carolina at Chapel Hill. Not only is JP a commercial real estate market expert & respected independent financial services strategist, but he's also a US Army veteran & father of five. JP's professional background is in interest rate derivatives aimed primarily at commercial & multifamily real estate. He works with brokers & borrowers looking at financing & wanting to manage their interest rate exposure on hedging strategies, which usually involve CAPs, swaps, & defeasances.

On December 2nd, SPI Co-Founder & Principal, Michael Becker ("MB") sat down with JP to learn more about his background & gain some insight into his perspective on how the rising interest rates play a role in the current & near future state of capital markets.

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MB: "JP, how would you define Interest Rate Caps in their simplest form?"

JP: "I think of Interest Rate Caps as an insurance contract," JP answered. "Say I want to borrow 10 million in cash from a lender to secure financing for some investment...if the Secured Overnight Financing Rate ("SOFR") index is at 0%, like it was at the beginning of the year, I can then purchase a 2% SOFR strike Rate Cap which ensures that, if SOFR rises to say 3%, the Rate Cap contract will pay me the difference of 1% on 10 million invested divided by however many days in the month capping the maximum interest rate," explained JP. "Sometimes these Rate Cap strike rates are determined by the lender, other times, clients just want to hedge at a certain level. Because Interest Rate Caps involve a lot of moving parts, our job at Pensford is to help walk our clients through all of the different considerations they should make before making such a purchase & in determining this structure so that they can best execute their business plan."

MB: "As sofr continues to rise & lenders continue to impound for their borrowers to repurchase a rate cap when it expires, what impact are you seeing for some of your clients with escrows?"

JP: "Yeah, I mean, escrows are up 10x or more...One of our client's escrows just jumped to $39K/month. Unfortunately, there's no 'magic wand' solution for this in sight, that impound is being driven by market costs divided by 24 months," JP expressed. "Normally, when an event like this happens, 70% of our clients reposition the same way, but that has not been the case this time. We've had some clients refinance floating to floating, forgoing cash flow in an attempt to take advantage of obtaining a higher strike that will lead to lower escrow amounts. Other clients have gone from floating to fixed that don't necessarily want a 10-year fixed interest rate loan, but recognize that their time horizon is long enough that they decide to risk a yield maintenance penalty to pick up some extra cash flow savings in the short term.”

MB: "how do you advise your clients considering transitioning from a floating to fixed interest rate loan?"

JP: “So, because it’s not our risk at the end of the day, we try to steer clear of making too strong of a recommendation & instead just provide our clients with things to consider. I would say that, yes, floating interest rates have been exceptionally painful recently due to compounding cap escrows. But, historically, the worst time to lock in a loan rate is during the Fed tightening cycle because that usually means that they’re going to be stopping & starting to cut at some point in the near future,” JP explained. “So, if you’ve traditionally been a floating interest rate borrower & you want flexibility, I would advise you not to abandon that rate now in light of the recent short-term disadvantages, likely in about a year or so there’s going to be a backside to this curve. Additionally, because borrowers are locking in higher rates relative to a year ago with pretty conservative underwriting terms, I can see a scenario where, 2 or 3 years later down the road, a lot of them are going to want to refinance at some point. And if they’ve locked in a long-term fixed interest rate, they’re going to have an expensive prepayment penalty,” JP advised. “If interest rates follow the typical path, which is within 2 or 3 years of the Fed starting a tightening cycle, the bottom falls out & rates are down 3% or more.”

“if you’ve traditionally been a floating interest rate borrower…

I would advise you not to abandon that rate now in light of the recent short-term disadvantages."

MB: "The 10-Year Treasury reached around 4.25% early last month & now we’re at around 3.50%…What’s going on? How did we get here? And, how do you predict the December hike will impact these rates?"

JP: “On the fixed rate front, I credit the 10-Year Treasury run-up due to the fact that economic data was still strong in addition to the Fed doing 4 consecutive 75 basis point hikes with inflation at a standstill. At this time, it made a landing point of 5% seem feasible. Since then, we’ve seen some small wins on the inflation front including yesterday when core PCE, which is the Fed’s preferred measure, came in quite a bit lower than expected (around 2.5% annualized). So, what we’re seeing is the market saying that not only is inflation cooling, but the economy is slowing, we’re entering a recession, & the Fed is going to begin cutting rates,” JP stated. “So, think of yourself as a bond buyer looking at buying a floating interest rate SOFR note at a 4% yield…You might lose out on some yield in the near, short-term, but a couple of years down the road, that rate is going to look pretty good… So, money starts coming into 10-year treasuries & pushing the yield down. I’d say there’s still a probability we could see it increase even more… Either way, I think that what everyone agrees on is that the economy is cooling, even if things like the labor market haven’t caught up yet. So, the Fed is going to have to come to an end at some point & we’ve already actually seen them starting to change its rhetoric around the tightening cycle,” JP resolves.

“On the floating rates side of the equation, it’s almost certain that the Fed will do 50 basis points at the December 14th meeting. I also expect at least another 25-point hike come February 1st & another 25-point hike come March 2023. Basically, the message that the Fed is sending right now is that they’ll put us at 5% at the end of March, & that while they’re slowing their pace, we’re probably going to end up higher than expected…like somewhere around 5.5%,” JP rationalizes. “If this ends up being the case, I think the most likely path after the March meeting is 2 more hikes leading into Summer 2023 before leveling off at 5.5%. Whether we end up at 5% or 5.5% will be driven by the economic data coming out, with inflation being the most notable… But, the end is certainly near & there is a light at the end of the tunnel,” JP stated. “Now, we’re just trying to measure when the Fed will stop hiking interest rates, because generally, on average, once the Fed stops, they begin cutting within 9 months, with the longest they’ve ever gone being 14 months. So, if the Fed stops in March of 2023, there’s a good chance they start cutting rates by the end of 2023 & certainly by early 2024. My personal instinct is that rate cuts are going to begin in early 2024 rather than late 2023 because the Fed keeps suggesting that they’re going to allow rates to be high & financial conditions to be restrictive in order to make sure they best stomp on the throat of inflation. So, my conclusive prediction is that we’ll have higher rates for longer, but the pace will slow substantially giving capital markets an opportunity to thaw a little bit in the first half of the year.”

MB: "As of now, agencies are still loaning money, but, by and large, banks are being extremely selective with borrowers & lending at much more conservative terms. Do you see a risk on appetite that will lead us to 2019 or 2021 kind of lending standards? Or do you foresee banks staying pretty conservative on their lending terms?"

JP: "Yeah, I think next year, base case scenario, lenders are still pretty conservative with their lending terms, but at least they’ll be willing to do some lending. I think right now banks are so worried about the final landing spot because one (1) we don’t know how to underwrite a deal if we can’t project the interest expense, two (2) all the loans we currently have on the balance sheet are stressed because they weren’t underwritten for SOFR being at 5%+, & three (3) we’d expected many of these loans to refinance by now, but instead, they’re being extended, which eats at our allocations for new financings. Truly, I think banks are just taking a pause in order to best evaluate how things are going to go in the near future,” JP construed. “When I think about this, I think back to the 2008 financial crisis & say ‘This feels totally different because banks didn’t even have money to lend,'” JP laughed. “As long as borrowers don’t start defaulting, lenders will eventually come back into the market…they’re not going to be able to just sit on their hands forever; People will get tired of sitting on the sidelines. Just like back in 2020, everybody paused and said, ‘Is this the end of the world?’ before realizing ‘Nope, it’s okay. Let’s get back to business.’ & then it just took off.”

“Just like back in 2020, everybody paused & said, ‘is this the end of the world?’

before realizing “Nope, it’s okay. Let’s get back to business.”

MB: "Say the Fed stops hiking interest rates in March, what will happen to Cap costs? How much of the Cap costs today is a risk volatility premium? And, how much essentially functions as pre-funding interest?"

JP: “Basically, the more ‘deep in the money’ the strike is, the more it functions as prepaid interest,” JP expounded. “We’ve had a lot of clients this year buy lower strikes because they figured ‘I’m not going to have to pay the interest expense anyway, so if I’m going to have a buy a Cap, I might as well put my money towards pre-funding interest & not into a nebulous volatility component that may or may not have value over the next 3 years,’” JP resolved. “A huge part of it though is volatility…Like I shared, I thought the Fed was not going to hike this year at all & now we’re going to land around 5%, so, now, I’ve got to charge my clients for the instance of 7-8% occurring; it’s a lottery ticket for me, so I’ve got to charge them for that…The good news is that we’ve actually gone & looked at previous Fed tightening cycles & found that when they end, Cap prices tend to plummet 50% in less than 3 months because all that volatility gets taken out of the equation. At this point, we’d stop charging 8% for the hypothetical scenario the Fed would then be signaling is not going to materialize.”

MB: "So, say the Fed stops hiking interest rates in March of 2023 & the 5% strike levels with SOFR, would it be fair to expect the volatility premium of the Cap cost to be around half of what it is now by Summer 2023?"

JP: "Exactly right."

MB: "And, what about the 2% strike in a 5% SOFR world What kind of drop in Cap costs should we anticipate by say, September 2023?"

JP: "By September 2023, Cap costs will certainly be less driven by that volatility component. Additionally, I predict that by then the market will begin realizing the Fed is cutting in advance of their prediction that rates will fall in early 2024, & for that reason, Cap prices should certainly be much lower at this time next year. My base case is a drop in Cap prices of at least 25%.”

MB: "So, do you predict that the Fed reaches 5% in March & then pause, or that they go to 5.5% through May or June?"

JP: "My base case is that we’ll probably reach 5% by March because I think we’ll see a lot of improvement in inflation & a lot of deterioration in economic data between now & then. If we start to see inflation coming down, the Fed will begin to cut because there’s really no reason to keep hiking at that point, even if the labor market is underperforming & unemployment climbs. Inflation is the main driver here – if it’s still persistently increasing, the Fed will keep hiking.”

MB: "When the Fed begins to cut, how many basis points at a time do you expect?"

JP: “By the time the Fed begins to cut in what I expect to be Q1’24, it will largely depend on market stability & the labor market. If at that point we’re losing 500,000 jobs/month, I think they’ll drop 3% in a year or less. Otherwise, I predict it will be much more gradual – probably like 50 basis points, followed by 50 basis points, then 75 basis points, & then they’ll see if they can drag it out without letting inflation creep back in,” JP justified.

MB: "What do you predict will be the Fed Funds interest rate by the end of 2024?"

JP: “I predict that by the end of 2024, interest rates will land somewhere between 3-3.5%. In the past, the average drop is around 2.75%. We’ve gotten comfortable with the idea that interest rates go right back down to 0%, but if they don’t have to, they won’t. So, 3-3.5% seems like a more reasonable expectation.”

MB: "Based on that, come 2025, do you see SOFR in the 2-3% range & not 0%?"

JP: “That’s my prediction, yes,” JP affirmed. “Unless there’s some sort of exogenous shock that forces the Fed to ‘slash & burn’ rates to 0%, I believe they’re going to avoid going down to 0% as much as they can. I think they will use somewhere around the 2.5% range as a new baseline by that point & start underwriting deals using that, not 0%.”

MB: "What about the 10-Year Treasury Rate? Where do you see us finishing this year & next year?"

JP: “This year, I think we’ll finish between probably 3.75%, maybe 4% on the high side. Next year, in 2023, I would predict it’s probably 3% or lower as the market prices drop.”

MB: "When do you expect to see loan spreads come in?"

JP: “I predict that spreads could start to come in in the first half of next year. It will be highly correlated with when the Fed begins to level off & capital markets begin to fall. We’re just waiting to know what rules to play by as soon as the Fed signals to us that they’re done hiking interest rates so we can all go back to our spreadsheets & start working again. Until then, we’ll continue to cautiously underwrite.”

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