By the Numbers
Parsing fast prepayments in Freddie K floaters
Mary Beth Fisher, PhD | September 24, 2021
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Traditional analysis comes up a little short for investors trying to understand prepayments in Freddie Mac K floating-rate loans. Regardless of loan structure, prepayment penalties, credit quality or interest rate environment, the average age of loans at payoff has been just under three years. A decade of strong price appreciation and burgeoning liquidity in multifamily finance has attracted investors who effectively use the loans as bridge financing to buy, rehabilitate and reposition properties for resale. Prepayment speeds are unlikely to materially slow without some relief in the current housing shortage, which could take several years. Meanwhile, investors in Freddie K floaters should continue to expect both 7- and 10-year floating-rate deals to have a duration of three to four years.
The original maturity, the amortization schedule, the length of the IO period, even the credit quality of the underlying loan has had virtually no impact on prepayments in Freddie K floating-rate loans over the past decade. Floating rates have been below fixed rates for most of that time, limiting the incentive to refinance purely based on rate reduction.
Structural features of Freddie K floating rate loans
Most floating rate loans have a lockout period of 12 months, followed by a prepayment penalty of 1% of the outstanding balance until the loan has four months left to maturity. The last four months is in the open period where the loan can prepay without penalty. Freddie has the option of waiving the penalty fee, which it does if the borrower refinances into another Freddie Mac loan.
There are some variations: some loans have declining penalty points or slightly shorter or longer lockout periods. A handful of loans have no lockout period, but many of those have penalty points that start at 3% or 5% of the outstanding balance and drop by 1% each year, similar to Ginnie Mae project loans. In 2020 and 2021 there appear to be more loans with longer lockout periods of 24 months to 36 months. Overall, those are still a small percentage, but it’s meaningful given the recent high prepayment speeds.
Notable trends in Freddie Mac floating rate loans are summarized in Exhibit 1. These include that the average term of the loans has been getting longer. When the program began in 2011 most loans were 7-year loans (84 months). Over time the loans have migrated to longer terms, with most new floating rate loans having 8 to 10 year terms (96 to 120 months). The average length of the interest only (IO) period has also extended along with the maturity of the loan, from 30 months to more than 50 months.
The credit quality of floating rate loans has remained relatively stable over time, with an average LTV of about 70% and occupancy rates at 95%. The debt service coverage ratios have varied, peaking in 2013-2014 above 2.0 DSCR, and have fallen back to about 1.5 DSCR for recent vintages.
Exhibit 1: Summary characteristics of Freddie K floating rate loans
Trends in prepayments
Despite the longer maturities and longer IO periods, floating rate loans tend to prepay at under 3 years (Exhibit 2). Of the nearly 2,800 floating rate loans that have paid-off, only eight were held to maturity (0.2%). About 24% of loans have prepaid without penalty, refinancing into another Freddie loan; and 75% have prepaid with penalty. The average age of the loan at the time of prepayment is 30 months.
Loans that are prepaying with a penalty tend to prepay five months prior to the expiration of their IO period, whereas loans that are refinancing into another Freddie loan prepay on average two months before to the expiration of the IO term. The loans where the borrower pays the penalty have a somewhat higher DSCR of 1.70 compared to 1.65, but it’s not a statistically significant difference. Otherwise, the credit characteristics are roughly the same.
Exhibit 2: Breakdown of prepaid loans in Freddie KF deals
This analysis is consistent with Amherst Pierpont’s prepayment reports for KF deals, which show 30 to 40 lifetime CPR for pre-2017 vintages, with speeds tending to hit 40 CPR in the third year (Exhibit 3). The impact of 30 CPR for investors is to lower the average life of the AS class of a new 10-year floater from 9.5 years to 3.5 years.
Exhibit 3: FHMS K-F Floater prepayment speeds
Original loan term (5, 7, 8, 9, 10 years), amortization type (full amortization, balloon amortization, full IO, partial IO), LTV, DSCR, occupancy and basically anything else you can think of – currently and for the last seven years – has no impact on the speed of prepayments (Exhibit 4). The 5-year loans tend to wait until months after the IO period is over to prepay, while the 10-year loans will prepay two years on average before the IO period is over. The loans that are complete IO prepay on average at 30 to 32 months as well. This hasn’t appreciably changed since 2014.
Exhibit 4: Prepayments based on loan characteristics
The question is why none of these factors are influencing prepay speeds and could this change in future?
Prepay speeds are being driven by a combination of very high multifamily transaction volumes amid very strong price appreciation across the sector (Exhibits 5 and 6). Sales volume and property prices have been increasing steadily over the past decade. Based on commentary from several originators, the high sales volume is partially due to real estate investors (REITs, private equity, life insurance cos, etc.) buying properties then selling them to hit IRR targets in 3 to 5 years. Their investment timeline is shorter, the price appreciation in multifamily has been leading all other CRE sectors for a decade, and they can often use Freddie loans to buy a property and make modest improvements and reposition it, then resell it quickly. Smaller investors could refinance and take out equity themselves, and that’s probably the 25% of loans that refi into another Freddie loan.
Exhibit 5: Multifamily property transaction volume (US)
Exhibit 6: Multifamily property prices (US)
As price appreciation slows, transaction volumes will begin to fall and prepayments will undoubtably extend. Capitalization rates are at all-time lows for apartment buildings (based on RCA data), and price appreciation certainly has to slow down or stall at some point. That’s not likely to happen while the Fed is still buying agency MBS and CMBS though, or while there is still a pronounced housing shortage.
For right now those 7-year and 10-year Freddie K floaters really have projected weighted average lives of three to four years. The world could certainly look different three years from now when current origination loans are expected to start heavily prepaying. Rates should be higher, price appreciation should have slowed, and transaction volume may tick down.