By the Numbers
Relative value across the CMBS floater landscape
Mary Beth Fisher, PhD | April 29, 2022
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.
Volatile markets and an aggressive Fed have increased investor interest in CMBS floaters. There are a wide range of choices in discount margins and weighted average lives. But one important consideration is the underlying benchmark: backward-looking 30-day compound average SOFR, which is used by Freddie KF deals and most CRE CLOs, or forward-looking 1-month term SOFR, which has become the standard in SASB deals. The spread difference between the two is currently 45 bp. And although discount margins have been widening along with the market since late 2021, there are signs of stability.
Freddie Mac began issuing floating-rate classes benchmarked to compound average SOFR in late 2019. CRE CLOs and SASB floating-rate deals did not fully switch to SOFR-benchmarked issues until this year. The switch to SOFR has been a little bit bumpy, but it’s easier now to compare relative value across the three main CMBS floater categories:
- Freddie KF AS classes,
- AAA-rated CRE CLOs (A and AS classes), and
- AAA-rated SASB A classes.
Freddie Mac floating-rate loans can have a final maturity of 5-, 7- or 10-years although most are 7- and 10-year finals. The loans tend to prepay on average at about 33 months, and the deals show a weighted average life between 3 and 4 years. Multifamily borrowers have often used these floating-rate loans to fix and flip properties, as the typical structure is for the loan to have a 2-year lockout period followed by a prepayment penalty of 1%. A complete discussion can be found in Parsing fast prepayments in Freddie K floaters.
Exhibit 1: Freddie Mac KF discount margins may still be widening
Discount margins on new issue KF deals maintained a low of about 20 bp through most of 2021 and began rising late in the fourth quarter. So far, spreads have steadily widened to about 40 bp in 2022 with another deal expected to price the first week of May. These spreads are still below their pre-pandemic levels of 50 to 60 bp.
Exhibit 2: CRECLO AAA floater margins appear to have stabilized
CRE CLO AAA-rated floaters have shorter WAL and wider spreads than KF loans
CRE CLO collateral has a 5-year final maturity, compared to most 7- and 10-year Freddie K loans. Loans in CRE CLOs are typically both prepayable and have extension options. A 2-year loan may have three 1-year extension options, and a 3-year loan may have two 1-year extensions. This means there can be a significant amount of duration drift across the classes. The A class has a shorter WAL than the AS since they pay down sequentially. The A classes of these CRE CLOs have an original WAL of 2.75 years at issuance on average. The AS classes are slightly longer with an original WAL of 3.32 years on average. With extensions a CRE CLO can have a similar WAL as a Freddie KF deal of 3 to 4 years, though in most cases without the additional extension risk beyond 5 years. It’s technically possible in some managed CRE CLO deals for the manager to allow a loan to extend beyond 5 years, but it’s unusual.
In theory and in some circumstances in practice, there should be no difference between floaters indexed to backward-looking versus forward-looking SOFR. The BDS 2022-FL11 deal priced an ATS class indexed to forward-looking, 1-month term SOFR and an ACS class indexed to backward-looking, 30-day compound average SOFR. Both classes were priced with a discount margin of 180 bp on 4/4/2022 (Exhibit 2, overlapping points on the right hand side of the chart). However, that was in early April when the spread between the two indices was 15 bp. More investors appear to be requesting classes indexed to forward-looking SOFR, and some are migrating to SASB floaters where that is already the standard.
SASB AAA-rated floaters have shortest WAL, wide margin range
The original WAL of the AAA-rated A class of single asset, single borrower (SASB) averages just under 2 years. This is the shortest average WAL profile of CMBS floaters. Most SASB A class floaters have a shorter WAL and similar margins to CRE CLO A class floaters (Exhibit 3). SASB spreads appear to have shown a bit more stability overall in 2022 than CRE CLOs or Freddie Ks, but that is offset by the wide margin range across credits. Industrial and multifamily properties tend to price and trade tighter than retail and office properties, reflecting greater strength in those sectors.
Even in the AAA tranche, discount margins are somewhat sensitive to the property type and credit profile of the underlying asset. For example, four recent deals that priced during the first week of April had discount margins ranging from 164 bp to 309 bp at pricing (Exhibit 3). Given the recent market volatility, none of these deals priced at par. For example. the NCMS 2022-JERI A class had a floating rate of 1-month term SOFR + 140 bp, but priced at 97.08, resulting in a discount margin of 309 bp to original WAL (1.74 years).
In the reverse of CRE CLOs, most SASB floaters are indexed to forward-looking 1-month term SOFR. One exception was the JPMCC 2022-ACB deal, priced March 9, which issued it’s A class indexed to SOFR30A. This makes SASB floaters more attractive than CRE CLO floaters indexed to term SOFR in a rising rate environment.
Exhibit 3: SASB AAA-rated floater margins are very credit sensitive
The impact of the floating rate index
Given the rising rate environment, investors are pushing for classes indexed to forward-looking SOFR as opposed to backward-looking SOFR in part due to the substantial difference between the two. Forward-looking 1-month term SOFR is currently 74 bp compared to backward-looking 30-day compounded average SOFR which is 29 bp (Exhibit 4).
The backward-looking index will catch up to forward-looking SOFR assuming that the Fed does raise rates by the amount and on the schedule as what is currently priced in. In a declining rate environment, the reverse will also be true – forward-looking SOFR will fall ahead of backward-looking SOFR, which will reflect the rate drop steadily over time.
Exhibit 4: Forward- vs backward-looking 1-month SOFR