By the Numbers

About those CRE CLO interest rate caps

Mary Beth Fisher, PhD | November 3, 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.

A triple witching is vexing CRE CLO investors. First, many ultra-low interest rate loans made in 2020 and 2021 are hitting their initial maturity date, and borrowers typically have to replace those caps to qualify for an extension. Second, after 525 bp of interest rate hikes, these low-strike, deep in-the-money caps can be prohibitively expensive to replace. Third, although CRE CLO managers have considerable flexibility to modify loan terms to deal with the caps, the disclosure of these modifications is so opaque that it’s difficult for investors to assess their potential impact on performance. Despite these challenges, substantial credit enhancement combined with de-levering as loans begin to pay off typically provides ample protection for the ‘AAA’ classes even if overall collateral performance weakens through 2024.

The collateral backing commercial real estate collateralized loan obligations (CRE CLOs) are transitional or bridge floating-rate loans that typically have initial 3-year terms with two 1-year extension options. Borrowers are usually required to purchase an interest rate cap for the first 3-year term then buy a new cap at the original strike during each extension period. The ultra-low interest rates and accelerating property price appreciation of 2020 through early 2022 produced a surge in transitional lending and CRE CLO issuance. Those 2020 and 2021 loans are beginning to hit their initial maturities—and will continue to do so throughout 2024—and borrowers need to replace their now deeply in-the-money, low-strike interest rate caps to qualify for each extension.

An example CRE CLO, the AREIT 2021-CRE5 deal, shows collateral details of the underlying loans, and how the interest rate caps impact the borrowers’ loan payments (Exhibit 1):

This AREIT deal is 67% multifamily, 11% office, 8% industrial, 7% retail and 8% hotel.
Performance so far has been good: there has not been a single delinquency of any loan payment and no loan has been in special servicing. One loan was in forbearance during Covid, which is noted as a modification, but has since cured.
One loan, the Cross Island Plaza office loan, paid off early with prepayment penalties.
Maturity dates, which are typically three years from issuance, range from 12/6/2023 to 9/6/2024. Final extended maturity dates (not shown) are two years after the maturity date for each loan.
The strike rates on the interest rate caps vary from a low of 15 bp to a high of 250 bp; the most predominant strike rate is 200 bp. Based on the scheduled interest payments, the cap providers are covering from 26% to 59% of the monthly payment.
As these loans roll through their maturity dates over the next one to two years, they normally will need to replace the interest rate caps at the strike rate for each 1-year extension option.
The cost of a new, 1-year cap on 1-month term SOFR is currently 3.16% of the notional balance, or the amount of the current balance of the loan.

Exhibit 1: Interest rate cap payments are currently covering over 1/3 of debt service in AREIT deal

Note: The floating rate index for all loans is 1-month SOFR. Only one loan, the DoubleTree by Hilton, has started to pay any principal. All others are still in the interest only period. Data from 10/1/2023.
Source: Intex, Santander US Capital Markets

Loan modifications can alleviate some cap pressure

CRE CLO managers and sponsors have considerable leeway to make modifications to performing loans that can reduce the cost or pressure of replacing the interest rate caps. The amount of flexibility depends in part on what is laid out in the loan documents and the deal prospectus or offering circular supplement. For example, in the AREIT deal mentioned above, loans are required to have interest rate caps for each extension unless the extension is for 90 days or less. Then the cap requirement can be waived. However, even if the extension is for a full year, the loan terms can be modified in a variety of ways that could reduce either the cost, requirement or constraints imposed when borrowers need to purchase a new cap.

Material modifications of performing loans fall into one of two broad categories: administrative modifications and criteria-based modifications.

Administrative modifications– generally routine in nature, including modifications to exit, extension and prepayment fees; yield and spread maintenance provisions; financial covenants; reserve account balances; interest rate floors and future advance conditions.
Criteria-based modifications– more substantive in nature, these generally include changes in interest rate; increase in principal balance; delays in payment of principal; change in maturity date; and permission for borrower to incur mezzanine debt or additional preferred equity. There are typically conditions attached that the modified loan still satisfy eligibility criteria, the note must pass note protection tests, and the rating agencies will not downgrade the securities based on the modification, among others.

Administrative or criteria-based modifications cannot be performed on loans that are: credit-risk loans; specially serviced loans; or defaulted loans. For a complete discussion, please see A primer on CRE CLO loan modifications.

When it comes time for the interest rate to be replaced, sponsors could change the strike rate required on the cap, allow money from the reserve balance account to be used to pay for the cap, or allow the borrower to deposit additional funds to offset the change in the strike rate. In deals where the interest rate cap is tied to a level of the debt service coverage ratio, those terms can be changed so the DSCR level is lower and easier to satisfy. As long as any modification still satisfies the note protection tests and the rating agency requirements so the securities will not be downgraded, there is considerable flexibility to work with borrowers on performing loans.

Disclosure of modifications is opaque

The downside for investors is that the data transparency and disclosure rules for CRE CLOs haven’t caught up with the complexity of the product. CREFC recently announced the CRE CLO Annex A Standard for data disclosure. This new standard increases the number of data fields that issuers will provide from 212 to 268, with many new fields specifically tailored to the CRE CLO structure. These include data on extension options and time periods for the extensions, interest rate caps and floors including their expiration dates, and more information regarding the original loan terms, fees and seasoning.

CREFC is planning a second phase of the CRE CLO reporting standards that will address the non-static nature of the pool collateral, so investors will be able to more easily track the addition and removal of loans throughout the life of the deals, and specialized fields for information regarding these transactions. It’s unclear what the timeline will be for the adoption of Annex A or the second phase of the release, but programmatic issuers are likely to adopt the new standard as soon as practicable.

Until these standards are finalized and adopted, investors are often left with terse and somewhat cryptic information about loan modifications and the replacement of interest rate caps. The loan modification data in particular may have a categorization, such as maturity date extension, forbearance, or other, but provide little to no information beyond that note.

Mary Beth Fisher, PhD
marybeth.fisher@santander.us
1 (646) 776-7872

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