By Nick Bertino, Tony Petosa, and Matt Herskowitz
For over a decade, commercial real estate investors had the wind at their backs when it came time to refinance their properties. In most cases, due to declining interest rates and increasing property values, borrowers were typically able to refinance into lower interest rates and pull out additional cash beyond their maturing loan balances. Additionally, shorter-term variable rates with flexible prepayment structures offered even lower rates than fixed-rate loans, allowing those borrowers who were comfortable taking on more interest-rate risk to boost their returns and execute cash-out refinances in intervals as short as two to five years. While variable rate loans typically require borrowers to purchase interest protection, such as an interest rate cap or swap, these hedging instruments remained relatively cheap to purchase during a low-interest rate environment. Variable-rate loan options also served as a backstop for borrowers whenever a sporadic short-term increase in fixed-rate Treasury yields occurred.
For many investors who had only experienced a low inflation, declining interest rate environment there was no reason to expect a change in long-term trends. The 10-year treasury yield reached nearly 16 percent in 1981 but persistent tightening from the Fed ultimately tamed inflation and led to a prolonged decline in Treasury yields with the 10-year index dropping to 0.52 percent in 2020. Removing the recent pandemic lows, the 10-year treasury yield hovered in the 2 percent range for most of the previous decade.
But today, things are different. After pandemic-related conditions and government stimulus resulted in inflation spiking to double-digit levels in some categories, the Fed ultimately made a dramatic shift in policy. Over the past two years, we have seen a drastic increase not only in U.S. Treasury yields (the index tied to most fixed rate loans) but also SOFR (which has replaced LIBOR as the index tied to most floating rate loans) after the Fed increased rates eleven times. Faced with the headwinds of higher fixed and variable interest rates, it is now more critical than ever for borrowers to evaluate how they plan to build and design their real estate debt portfolios.
Borrowers who are currently holding variable rate loans in their manufactured home community portfolios are not only paying higher interest rates than they originally started with, but are also saddled with higher costs related to purchasing interest rate caps, which are typically required by most lenders, including Fannie Mae and Freddie Mac (the Agencies). As it relates specifically to the Agencies’ variable rate loans, at the time of loan origination borrowers were often required to purchase either a 3-year or 4-year renewable interest rate cap. Recognizing the increased cost of interest rate caps as required by their programs, today both Agencies provide flexibility related to reducing the required term on renewal caps to as short as one year. Given the higher costs of interest rate caps in today’s environment, variable rate borrowers whose initial rate caps are nearing the expiration date would be wise to reach out to their loan servicer to see if a shorter-term, and therefore less expensive, interest rate cap might be an option.
As mentioned above, in prior years variable-rate debt was often viewed favorably by borrowers seeking shorter-term loans with low interest rates and prepayment flexibility. And for other borrowers, variable-rate loans served as a viable backup option during times when fixed interest rates spiked. But in today’s market, SOFR has risen to a level where the starting rates on variable-rate loans can be as much as 2 percent higher than longer-term fixed-rate loans. As a result of these high rates combined with the now higher costs of interest rate caps, demand for variable-rate loans has declined substantially. As a way to fill this void, the Agencies are now offering more aggressive underwriting and pricing on their 5-year fixed-rate structures; essentially providing this option as a proxy to variable-rate loans. For most transactions, they will underwrite to as low as a 1.25x minimum debt coverage ratio on 5-year loans and also provide flexible prepay options, such as 3 years of yield maintenance followed by a 1 percent prepayment penalty or 3 years of yield maintenance with the last two years of the loan term open to prepayment without penalty. Additionally, since these are fixed-rate loan structures, no interest rate caps are required, providing further cost savings versus variable-rate loan executions. A shorter fixed-rate term may also be a viable option for traditional fixed-rate borrowers who need to refinance into new debt but are forecasting that interest rates will be lower in five years as compared to where they are now and are therefore hesitant to lock in longer-term fixed-rate debt.
So, what about borrowers with properties currently encumbered by fixed-rate loans that are still a couple of years from maturity and have prepayment penalties?
Question Conventional Wisdom
Conventional wisdom would say it probably makes sense to hold fixed-rate loans to maturity since the existing interest rates on those loans are likely lower than what can be obtained in today’s market. But, perhaps this is when you might want to question conventional wisdom. As a first step, borrowers analyzing their existing debt portfolios need to ask themselves whether they believe interest rates will be higher at the time their loans mature. It is important to note that fixed-rate loans are typically subject to yield maintenance or defeasance prepayment penalties, and these prepayment penalties diminish over time assuming a steady or increasing interest rate environment. Given how drastically Treasury yields have increased, fixed-rate loans maturing over the next two to three years with a standard yield maintenance prepayment structure may be able to be paid off with as little as a 1 percent prepayment penalty (the minimum penalty typically associated with yield maintenance) while loans subject to defeasance may actually be able to be paid off at a discount. For borrowers who are of the opinion that interest rates will be higher two to three years from now, it likely makes sense to refinance early if they can pay their loan off with a minimal prepayment penalty while at the same time locking in a new long-term fixed rate prior to rates increasing further.
Given we are experiencing a unique period in our economic history where we saw reignited inflation cause a dramatic shift in monetary policy, we believe this to be an optimal time to revisit your short and long-term assumptions on the economy and future interest rates. While the Fed is determined to battle inflation, there are some structural challenges that lay ahead such as a declining workforce and the risk of wage-price increases that may result in rates remaining higher for longer. We also suggest reviewing the terms of your existing loans for key prepayment provisions and dates and confirming that your real estate schedule is up to date. Developing a financial business plan is now more challenging, but we recommend starting by forming future assumptions on rates around your maturity dates and then designing your debt portfolio accordingly.
Tony Petosa, Nick Bertino, and Matt Herskowitz are loan originators at Wells Fargo Multifamily Capital, specializing in providing financing for manufactured home communities through their direct Fannie Mae and Freddie Mac lending programs and correspondent lending relationships. If you would like to receive future newsletters from them, or a copy of their Manufactured Home Community Market Update and Financing Handbook, the authors can be reached at tpetosa(at)wellsfargo.com, nick.bertino(at)wellsfargo.com, or matthew.herskowitz(at)wellsfargo.com.
