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Multifamily Investing Show | Ep. 12

The LoanBoss Team Feb 23, 2021 9:15:00 AM

JP Conklin joins SPI Advisory Principal Michael Becker to talk market forecasting, strategy, and why inflation won't be a concern for borrowers.


What kinds of interest rate derivatives does LoanBoss help track?

1. Caps. Interest rate caps are the most plain vanilla way to hedge your interest rate; it's nothing more than a ceiling on your index (most commonly LIBOR over the years but now increasingly transitioning to SOFR, led by Freddie and Fannie). All this does is ensure your floating rate never goes above a certain level.

Typically, Agencys will have some sort of max rate they don't want borrowers to exceed for risk purposes, and they will use that to back into the strike the borrower has to buy the interest rate cap at. A very common strike today might be around 2.00%, so Freddie might require you get a cap at 2.00% indexed against SOFR so they know your worst case all-in interest rate is 2.00% + loan spread.

The borrower pays an upfront premium as determined by the hedge provider, usually out of closing, and sends the Confirmation to their lender to prove compliance with hedge requirements. When you pay the upfront premium, you will never have to pay any more than that, and if your index exceeds the strike then the hedge provider will pay out the difference to pass through to the lender. If the index never exceeds the strike, you'll never know the difference. And if you terminate early, you can be reimbursed any remaining value of the cap.

2. Swaps. When you switch over to look at, say, a Balance Sheet lender, you may see some caps, but you'll also start seeing alternative structures such as swaps. Far and away, the biggest consideration when entering into an interest rate swap is what your potential prepayment penalty is going to look like. It's the same type of calculation as a defeasance or a yield maintenance - you've locked in a rate and if rates have gone down then you'd owe the bank the difference, and vice versa. So the terms are very important to negotiate when coming to the closing table, since that will have a major effect on who owes who - and how much - if rates move.

The first question we like to ask someone when they're considering whether to lock in for five, seven, ten years, is "what's the disposition plan?" If you plan on exiting your financing in three years, you probably shouldn't consider a ten year swap. Conversely, a ten year swap could make a lot of sense if you plan on holding for ten years.

 

One big difference between these two instruments is the term's effect on cost. Generally speaking, swaps look very attractive at that ten year mark, and caps look very attractive for about a two to four year term. Why? It's all about rates, risk, and volatility.

What's the difference in prepayment calculations between swaps and defeasance or yield maintenance?

For the most part, the difference between a defeasance / yield maintenance as compared to a swap is that you can actually benefit monetarily from your swap. Whereas, a defeasance or yield maintenance only benefits the lender. 

There are extreme scenarios in defeasances where you could get paid, but it's incredibly uncommon because the spread on top of Treasurys or swaps is against you on day 1. So not only would you need rates to go up, you'd need them to go up by more than that spread. For instance, if it's Treasurys + 2.00%, you'd need rates to go up by more than 2.00% just to get back to 0.

With a swap, you don't have the spread working against you. So on day 1, minus the bank's credit charge, it's basically neutral to you. The minute rates start rising, it could be in the money.

Is there a third or fourth hedging option?

3. Swaptions. This is just an option on swap rates, and it's generally used by customers who would prefer fixed rate debt at some point in the future but might have uncertainties - which bank to go with, when exactly closing will be, etc. But they're worried about 10-year Treasury yields going up as they finalize these details. By paying an upfront premium today, these borrowers can protect against the 10T moving above a certain rate. 

These can also be useful protecting against the 10T going down. If rates have increased and borrowers are going to prepay a loan with a defeasance or yield maintenance, it's much more affordable to pay off with that higher rate. But if they're worried rates are going to drop back down in the next 30-60 days while closing, they can use a swaption to hedge against falling 10T rates and lock in that prepayment.

4. Collars. These give you the flexibility of floating rate exposure but also help you hedge. In an interest rate collar, you have a ceiling (let's say 2.00%) and a floor (let's say 0.25%), and you just float between the two rates. So your rate won't ever get away from you, but you won't benefit from rates dropping below the floor.

Biggest benefit of a collar? You don't have to pay an upfront premium like a cap requires. So if you don't want to see $50k in cash out the door, you may consider a collar.

With the 10T widening out, should we expect premiums to increase on derivatives like caps?

Not at all.

Caps are generally in that two to four year range, and the front of the curve is not going anywhere. The front of the curve is so directly controlled by Fed monetary policy, that even though the 10-year end has popped up, the next few years are firmly anchored close to 0. Plus, the Fed has made it abundantly clear that there will be no hike any time soon. So you have to go out about three years to even see the market price in one hike, and that's earlier than what the Fed is saying they plan on doing. They're really targeting 2024. 

From an interest rate standpoint, if you're offering an insurance contract on 2.00% on LIBOR, and the people that control LIBOR say they won't be anywhere near 2.00% in the next three to five years, it'll be cheap.

So with the 10T widening, what we're actually seeing is borrowers who were considering a CMBS loan start to look at floating rate alternatives and maybe pick up a point.

What's happening with floors in loan agreements?

The last time interest rates were at 0, it took about eight years for them to get off of 0, so we should not assume this time around will only take three to five years. There is a very real scenario in which LIBOR is still anchored low in six or seven years, so having a floor can have a real economic impact.

However, borrowers have been able to explore their options when it comes to lenders. Six to nine months ago, if a lender quoted a 1.00% floor, you were going to end up stuck with it. But now, you can likely line up a few different lenders and make it a point of negotiation to get as close to 0.15% as possible.

With the end of COVID hopefully on the horizon, what's likely to happen in the market?

The market expects the Fed to be on hold until at least 2023 and starts pricing in one hike at the end of that year - that is the direct result of Fed guidance. The Fed has said they do not plan on hiking until 2024, so the market slightly disbelieves that but not a lot. Even if you go out to five years, however, the market has LIBOR peaking at 1.25%. So it is going to be a very long, slow cycle until we see the front end of the curve - the floating rates - drive up meaningfully to the point where someone might pick a fixed rate over the floating alternative.

On the long end of the curve, rates have popped up. The 10T has reached its highest point since the beginning of COVID, and the reason is stimulus. Stimulus means higher growth, more jobs, and inflationary pressures. And after the Democrat sweep in Georgia, a $1.9 trillion bill suddenly looks much more likely, on top of the other stimulus bills that have been passed, and the market interprets that as greater deficit and thus greater inflation. Since inflation is public enemy number one for bonds, it suggests to get out of bonds - and when you sell a bond, the interest rate rises. So we saw the 10T hit it's high.

So if you had a five year hold period on your loan, should you fix or float in 2021?

All else equal, you should probably float (and add a hedge just in case). There is low downside of floating, especially if you don't have an interest rate floor, because the Fed will allow the economy a lot of rope before it starts hiking. And if it costs you an extra point to fix, you'd need them to hike eight times just to average the 1.00% premium that you'd pay.

In a different world with a less transparent Fed, the answer becomes less clear. But the Fed is all about signaling way in advance - we'll know a year ahead before they start hiking. In 2023, they probably will start saying they'll hike at some point in the future, and then they'd actually hike in 2024.

What if your hold period is seven years, is it the same answer?

Well, what is the probability that you don't actually hold it for seven years? Everyone may think they stay in for the full term, but it's almost never the case. 

One client of LoanBoss had a report created to audit their financing decisions, and they found that they exited their ten year financings after three or four years. Rolling that term premium into their final effective interest rate, their rate wasn't 3.00% - it was more like 7.00%. If you had known your rate would be 7.00% at the closing table, would you have chosen that deal? Of course not, so if you're likely to turn over in three to five years, maybe consider a shorter term and/or floating.

Check out the New Deal Checklist we made with this firm, and ask yourself the questions they now ask before every new deal. Download here.

Any forecasts for SOFR this year?

Agencys will likely continue to lead the charge on the transition, and lenders/hedge providers will likely just let the LIBOR legacy contracts fade to black.

We expect to see more term sheets referencing SOFR. The net effect will be negligible - it will feel and act a lot like LIBOR for most borrowers. So it won't change much from that standpoint.

There is also such a regulatory spotlight on this transition, that it is incredibly unlikely banks use this as an opportunity to take advantage of borrowers. Everyone will probably just work together as best as possible to make the transition smooth, since no one wants to deal with the hassle of a few basis point differences in transitioning from one index to the next.

 

For more thoughts, email the boss at theboss@loanboss.com!