By the Numbers

Watch for rising prepays and defaults in Freddie floating-rate loans

| December 1, 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. This material does not constitute research.

The largest vintage of Freddie Mac’s floating rate K-series loans will roll into their interest rate cap replacement period in 2024. The high costs of these caps has coincided with an increase in multifamily vacancy rates, causing a weakening in credit metrics for some properties. Investors should get better value in KF deals from 2020 through 2022 vintages to position for faster prepayments, targeting those with pool factors that are higher than average.

The bulk of Freddie K floaters in the outstanding KF series were issued from 2021 through 2023 (Exhibit 1). The second highest year outright for total issuance was 2020, which had $21 billion of floaters issued, two-thirds of that balance had prepaid, leaving only $7.6 billion outstanding. Freddie’s largest issuance year for floating rate loans was in 2021, with nearly $30 billion in UPB issued and $17 billion still outstanding.

Exhibit 1: Delinquency rates in Freddie K floaters are rising

Note: Data through 11/30/2023.
Source: Bloomberg, Santander US Capital Markets

Floating rate loans in 7- and 10-year maturities typically have a weighted average life of 3.5 to 4.5 years (Exhibit 2). The loans are locked out from prepayment during the first year, but afterwards pool factors tend to drop sharply. The 10-year deals arguably have a bit more variability in the speed of paydowns, but both maturities currently have less than 30% of UPB outstanding by the time they reach the 5-year mark.

Exhibit 2: Pool factors of Freddie floating rate loan deals

Note: Data as of 11/30/2023.
Source: Bloomberg, Santander US Capital Markets

Particularly attractive opportunities exist in the deals with higher-than-average pool factors, like the 10-year deals which are 2- to 4-years post-origination with factors still above 0.50. These should pay down rapidly over the next 12 to 18 months. Many of these deals were issued when floating-rate discount margins were at historic lows of 20 bp, compared to current levels of 70 bp. These deals are trading at discount dollar prices, often with a low- to mid-98 handle.

Signs of stress

There are multiple indications that floating-rate loan borrowers have come under particular pressure as the Fed has raised interest rates. Signs of stress are emerging not only from the cost of replacing the interest rate caps, but due to some fundamental deterioration in credit quality.

The headline issue is the high cost of replacing the expiring interest rate caps. The interest rate caps that borrowers purchase at origination are typically for a 3-year term. Afterwards they are required to replace the caps each year and put aside reserves for the cap replacement. Loans originated in 2020 began to roll into cap replacement in 2023, which likely encouraged a lot of refinances and paydowns. It also resulted in a rise in delinquencies to 60 bp for a large pool of outstanding UPB.

The 2021 vintage loans will begin rolling into cap replacement in 2024. This is occurring at the same time that multifamily vacancy rates have been rising, and there is pressure on net operating income from both the lower rental income and higher expenses. As an example, below are excerpts from watchlist commentary for the Woods at Addison property (FHMS K79 deal). This loan is not delinquent, but has been on the watchlist since 9/19/2023 for financial conditions (edited for brevity):

The loan is on the watchlist due to a Floater DSCR that is less than 1.00x and less than 90% of NOI “in place” as of U/W. The UW DSCR was at a 1.57x and 97.8% occupancy. This loan was added to the WL on 9/19/23 due to financial concerns. At the time of adding to the watchlist, the Floating Rate loan DSCR was below 1.10. As of 6/30/23, the physical occupancy is 86% for 225 units, as compared to 90%, which was previously reported as of YE22. Current stressed DSCR is .76x as reported for the period ending 2Q23, compared to 1.96x reported for YE22. Driving factors are increases to Collections/Vacancy Loss, Payroll/Benefits and PFEES. AM has reached out to Borrower for additional insight to the increases of expenses and decrease in occupancy. Additionally, Rate Cap Escrow Monthly payments increased from $4,169 in 2Q23 (sic – this probably meant to read 2Q22) to $47,011 in May 2023.

The is not an isolated case. The overall delinquency rate in Freddie’s KF floating rate loan program is 59 bp of outstanding UPB. However, 14.7% ($9 billion / $61.4 billion) of UPB is currently on the watchlist, and an evaluation of those loans indicates that there has been a deterioration in financial conditions (Exhibit 3).

  • The average coupon on the loans has risen by 4.0%, with the loans which are late or delinquent showing larger increases. Higher borrowing costs will naturally put downward pressure on debt service coverage ratios.
  • The average drop in DSCR has been 15 bp, but the late and delinquent loans have experienced a much larger drop, and their DSCR’s are now below 1.0. That is one threshold for being put on the watchlist, though many changes in property financials or fundamentals can cause it.
  • A third issue for these watchlist loans is the 5% average drop in occupancy rates, again with the late and delinquent loans showing much larger drops. The drop in occupancy lowers rental income, which can have pass-through effects to decreasing net income.
  • The changes in net operating income are dramatic, with an average drop of 28%, while the properties backing the delinquent and late loans have experienced nearly a 50% decline.

Exhibit 3: Watchlist loans show a sharp drop in credit quality

Note: Averages are simple means, not UPB-weighted. Data as of 11/30/2023.
Source: Bloomberg, Santander US Capital Markets

Loan modifications can alleviate some stress

Freddie is working with borrowers to modify loans, particularly those that are struggling due to the high cost of the interest rate caps. As an example, the following is from the watchlist commentary for the Lakeside Homes property, the delinquent loan in FHMS KF79:

The loan transferred to Special Servicing effective 7/12/2023 for payment default. The subject is a 303-unit multifamily property located in Lansdowne, MD and was built in 1972. Beginning with the 5/1/2023 payment the Borrower has not been making full monthly payments; specifically, the Borrower has not remitted the Rate Cap Reserve for the 5/1 to 9/1 payment dates. As of July 2023, the property was 84.16% occupied. A modification has been approved by all interested parties and should be executed soon. Borrower’s counsel is in process of review the agreement. The modification will waive the rate cap reserve payments through and including the 1/1/2024 payment date.

These types of modifications should allow borrowers an opportunity to either sell the property or qualify for alternative financing and prepay the loan.

Watch for rising prepays and rising delinquencies

Prepayment penalties for Freddie floating rate loans aren’t paid to investors, but they are interesting to track because they indicate market dynamics. When floating rates were very low in 2021 and 2022, the percentage of KF loans that had their prepay penalties waived was in the mid-single-digits, about 5% to 7% on average. This is likely because borrowers were selling the properties, not refinancing the loans. Floating-rate CRE borrowers tend to be shorter-term borrowers that are opportunistic investors more so than long-term property managers or multifamily investors.

During average years, about 20% of Freddie KF loans that prepay will refinance into a fixed-rate loan. So far this year, that percentage has been 26%. That’s still on the high end of historical averages. It’s likely that more KF loans are pursuing a Freddie fixed-rate takeout because:

  • The sales market is so depressed the investors are struggling to sell the property at their previous target price; and
  • The floating rate caps that need to be replaced after year 3 for each subsequent year are still punitively expensive, and borrowers can get lower all-in fixed rates if they qualify for the loan.

Prepayments in floating-rate loans will likely accelerate as long term rates decline, allowing many borrowers the opportunity to refinance into a fixed-rate loan to escape interest rate cap constraints. Despite delinquency rates rising in agency and non-agency CRE loans, involuntary prepays are still close to zero.  As defaults build and loans are either removed from the pool or the loan is worked out, involuntary prepayment rates should rise. CRE loan workouts are a notoriously slow process though, and Fannie and Freddie workouts routinely take 18 months to several years. Those workouts are now just barely visible on the horizon, but they are coming.

Mary Beth Fisher, PhD
1 (646) 776-7872

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