Why You May Be Overestimating Your Interest Rate Expenses

As commercial real estate investors make future projections, they may be overestimating the interest expense for their debt, according to  Andrew Thornfeldt, managing director at Chatham Financial.

In a recent Chatham Financial webinar, 60% of attendees answered that they use the forward curve to project future interest rates. But Thornfeldt thinks they may be overestimating their costs if they rely on the forward curve to make their debt and derivatives decisions. 

“Historically, rates have just never followed the forward curve, and they’ve deviated from the forward projections in a meaningful, material and predictable way,” Thornfeldt says.

By looking at the forward curve, Thornfeldt says investors do not see all of the relevant market data points. “The problem is that they’re stopping there,” he says.

If they stop there, Thornfeldt thinks investors are not as thorough and prudent as they could be. Instead, it makes more sense for them to look at a broader range of potential outcomes.

“We have 30 years of history demonstrating that the forward curve is the best information we have in terms of what interest rates are projected to do in the future,” Thornfeldt says. “However, historically, rates have just never followed the forward curve. They’ve deviated from the forward projections in such a meaningful material way and in such a predictable way.”

If an investor is only looking at the forward curve, Thornfeldt says it is difficult to make predictions about future rate environments.

The discussion of the forward curve is pertinent because the yield curve is finally starting to steepen. “Interest rates are expected to go up in the future,” Thornfeldt says. “Historically speaking, the past isn’t necessarily the best predictor of the future. But oftentimes, a fairly good barometer is that when that yield curve starts to steepen, that is often the point where the forward curve overshoots what interest rates end up doing.”

Thornfeldt thinks it’s important for investors to recognize where the forward curve is incorrect. “Often, the forward curve assumes that rates are going to be higher than they ended up being,” he says.

An institutional investor comparing a fixed rate loan to a floating rate loan will find that the floating rate loan historically has outperformed relative to initial underwriting because rates have ended up being lower than what the forward curve suggests Thornfeldt.

“The inverse by definition is also true, which means if I am a fixed-rate borrower, I have historically lost in a pretty material way,” Thornfeldt says. “Every time you enter into a fixed-rate loan or a LIBOR swap, you are essentially locking in the forward curve at that point in time. And because historically speaking, the forward curve has always overshot or over-predicted what rates end up doing, that has been a really bad trade.”