CREFC Capital Markets Update
May 23, 2022
Hedging Cost Increase Surprises Borrowers
Last week, an article in Bloomberg highlighted the dramatic increase in hedging costs for floating-rate commercial mortgages in recent months. Lenders almost always require that borrowers obtain interest-rate caps on floating-rate loans to protect against debt service payments soaring out of control in a rising rate environment. With the Fed raising rates twice this year with more increases planned, floating-rate indices have surged.
According to Chatham Financial, a risk management advisory firm, the cost for a two-year, 2% interest-rate cap on a $25 million mortgage was $52,000 in January 2022. That same interest rate cap in early May was $535,000, and prices for a similar three-year, 2% cap increased by 4,000%. “Last year, it would be like buying flood insurance for your house in the mountains,” said Chris Moore, a Managing Director at Chatham. “This year, it's sort of like buying flood insurance for your house on the beach as a hurricane is making landfall.”
Borrowers who need to refinance or extend maturities on existing debt may be in for the biggest surprise. “If a mortgage was taken out two years ago, when rates were very low, the cost of the rate cap was nothing,” said Lea Overby, Head of US CMBS Research at Barclays. “Now, it can change a borrower's decision at an inopportune time.”
Interest-rate cap costs will remain high for borrowers in the near term. The Fed is planning on additional half-point increases in June and July, and potentially even September, bringing the federal funds rate to 2.7% by the end of the year, up from less than 1% today. This is reflected in the SOFR forward curve, as shown below.
While the rising rate environment may push some borrowers to lock in fixed-rate financing, others may continue to opt for the flexibility of floating-rate loans. “If you think a recession is coming, then rates will eventually fall,’’ said Lisa Pendergast, Executive Director of the CRE Finance Council. “You may need to contend with higher rates for a period but then may take advantage of lower rates should the economy falter.’’
ARRC Endorses 12-Month SOFR Term Rate
On May 19, the Alternative Reference Rates Committee (ARRC) announced its endorsement of CME Group’s forward-looking 12-month SOFR term rate. The ARRC previously recommended CME Group’s 1-month, 3-month, and 6-month SOFR term rates. However, at the time of that endorsement in July 2021, the CME Group did not produce a 12-month SOFR term rate.
Further supporting the ARRC’s announcement was the continued development of SOFR futures markets. The ARRC notes that 12-month rates are relatively less used and therefore believes that the used of the 12-month SOFR term rate should be primarily for legacy products and in trade or receivables finance.
Macro Volatility Continues to Weigh on Issuance
- Private-Label CMBS and CRE CLOs. Only two private-label transactions priced last week:
- $609 million CRE CLO and a $761 million conduit transaction.
- As of May 20, CMBS and CRE CLO issuance stood at $63.1 billion, 32% higher than the same period in 2021 ($47.9 billion).
- According to BofA Global Research, there are 31 private-label transactions totaling ~$21 billion in the current pipeline consisting of eight conduit, 12 SASB, and 11 CRE CLO transactions. However, if the market volatility continues, it is highly likely that pricing will be delayed and timelines will be extended.
- Choppy macro conditions, including another sharp selloff in equity markets, led to another week of spread widening in conduit CMBS spreads:
- Spreads on 10-year super-senior AAA conduit CMBS widened by 2 bps to 128, while AA – A tranches widened by 19 – 24 bps to 215 – 275, and BBB- spreads increased by 29 bps to 515.
- The conduit transaction that priced last week saw the LCF AAA clear at 136 bps, 8 bps wider than the secondary market level (128 bps).
- Agency CMBS. Last week saw ~$6 billion in new agency transactions, consisting primarily of Freddie K issuance (~$4 billion) and Fannie DUS (~$1 billion). Total agency issuance reached $74.3 billion for the year-to-date period ended May 20. Agency issuance is down 7% from the same point last year ($80.0 billion).
- Agency spreads held on and were generally consistent, widening only 2 bps for senior Freddie K and 3 bps for Fannie GeMs bonds.
Senior Director, Research
Borrowers who need to refinance or extend maturities on existing debt may be in for the biggest surprise.
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