By the Numbers
Interest rate caps drive up prepayments in Freddie K floaters
Mary Beth Fisher, PhD | January 27, 2023
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.
Floating-rate loans surged in popularity among multifamily borrowers when short rates dropped to historic lows during pandemic. And one result was a surge of issuance in Freddie Mac’s floating-rate (KF) deals. Freddie Mac requires those borrowers to buy short-maturity interest rate caps on their loans and to replace those caps at the original strike rate throughout the term of the loan. The caps at origination typically have out-of-the-money strikes, but the rapid rise in interest rates has put strikes for most pre-pandemic and pandemic vintage loans deep in-the-money. The high cost of replacing the caps has already contributed to faster prepayments in KF deals. Investors seeking to benefit from the faster speeds should focus on pandemic-era deals that printed at very tight discount margins and are now trading modestly below par.
It’s tough to take advantage of floating-rate loan prepayments. Investors can’t benefit from prepayment penalty streams in KF deals the same way that they can in Ginnie Mae project loans. The prepayment penalties from KF loans go to the X class, which is retained by Freddie, because they waive prepay penalties if the borrower refinances into a fixed-rate Freddie K loan. Floating-rate securities, particularly those with monthly resets, have short durations and tend to trade very close to par. Changes in the required spread, or discount margin, can push floaters away from par, and there has been a relatively large change in discount margins in KF deals over the last few years (Exhibit 1).
Exhibit 1: Discount margins on Freddie K floating-rate deals
Discount margins (DM) were about 60 bp just prior to the pandemic, then fell below 20 bp at the tights in early 2021. They stayed below 25 bp through early 2022 before rising to a recent peak of 90 bp. The most recent KF deal to print, the FHMS KF149 which priced on January 18, came with a DM of 64 bp – solidly back into the pre-pandemic range but still 40 bp wider than the 2021 vintage deals.
The impact of the rise in rates on the weighted average coupons (WAC) of the deals has been pronounced (Exhibit 2):
- The WACs of late 2015 through 2017 deals, where there is still collateral outstanding, have increased by 250 bp to 400 bp. Those deals typically have only a few loans remaining that comprise 10% or less of the original balance (Exhibit 3)
- The 2018 vintage 10-year KF deals began with a WAC of about 4.00%, and at current rates those WACs have increased to 6.00%. This is notable because, very roughly speaking, the average strike rate on the interest rate cap is about 200 bp above the floating index at origination. Depending on curve shape and forwards, this would mean a borrower who bought an out-of-the-money cap at origination has to replace it with an at-the-money cap now
- The situation for late 2019 through 2021 vintage borrowers is worse. Their average WACs have risen from below 3.00% at origination to between 6.00% and 7.00% as of this month. Those caps are almost uniformly now deeply in the money for borrowers who need to repurchase them.
Exhibit 2: Change in the weighted average coupon since origination
The cap that the borrowers purchase at origination has a minimum term of three years, so the 2019 and 2020 borrowers have mostly taken one of a few actions:
- Had to repurchase a cap (funds for the repurchase are escrowed),
- Have refinanced and prepaid the loan, or
- Sold the property and prepaid the loan
A handful of borrowers buy longer term caps, but it’s fairly rare. When the original cap expires the new caps must have a term of at least one year. Borrowers facing the purchase of a new cap have clear incentives to prepay. For reference:
- The cost of a 1-year cap on 1-month LIBOR at the current at-the-money strike (4.85%) is about 18 bp, or 0.18% of the outstanding notional or loan amount
- The cost of a 1-year cap on 1-month LIBOR struck 200 bp in-the-money at 2.85% is 184 bp or 1.84% of the outstanding loan amount. That’s considerably more than the 1% prepayment penalty.
Exhibit 3: Prepayment speeds should accelerate sharply in 2019 – 2021 vintage 10-year KFs
Not surprisingly, prepayment speeds for floating rate collateral increased from 33 CPR in December 2022 to 43 CPR by June 2022, based on Freddie Mac’s most recent prepayment report. Amherst Pierpont prepayment reports across deals show than many have sustained speeds of 30 CPR to 60 CPR in the second half of 2022. Those fast speeds are likely to persist as the 2020 and 2021 borrowers close in on the expiration of their initial interest rate cap and are forced to decide whether to repurchase a cap or prepay the loan.
Floating-rate borrowers are often more rate sensitive and opportunistic than fixed-rate borrowers. They can prefer floating rate loans because the prepay penalties are lower at shorter investment horizons, which gives them more flexibility. The upside is that borrowers whose caps are expiring have 3 years of strong property price appreciation and rent growth. This likely increases their ability both to either sell the property, refinance into lower fixed rates or simply purchase another cap. It will be interesting to see if transaction volume picks up as some investors choose to sell.