Agency ARM and interest rate cap update

As we move through the third quarter of 2020, we are coming closer to one of the more significant LIBOR transition milestones for commercial real estate (CRE) borrowers, specifically for those in the multifamily space. As announced in February of this year, Freddie Mac and Fannie Mae intend to transition away from the use of LIBOR in their floating-rate loan products, and instead use SOFR as the base rate index for these loans. Despite the broad market disruption caused by the COVID-19 crisis, Freddie and Fannie have indicated that they continue to be committed to this timeframe. Consistent with their stated timetable, Freddie and Fannie published their LIBOR Transition Playbook at the end of June, and our ongoing conversations with them and their seller-servicers echo this. Given the imminent timeframe for this transition, we wanted to refresh our readers on this timeline and some of the interest rate hedging logistics surrounding it.

As laid out in the Playbook, several key dates associated with this transition are quickly approaching. In the near term, both Freddie and Fannie have indicated that loan applications for SOFR-indexed loans are coming soon, with Freddie indicating that they will be available starting September 1, 2020. Fannie has indicated that these will be available sometime in the fourth quarter of 2020. We have heard anecdotally from some market participants that they may be available even sooner, beginning in August. The Agencies will stop accepting applications for LIBOR-indexed loans after September 30, 2020 and will cease to purchase them after December 31, 2020.

Freddie and Fannie have also determined the loan structure and interest conventions to be used in their multifamily ARM products. While there is still much discussion in the market broadly about how SOFR-indexed loans will work (given that SOFR is a daily rate, not a monthly term rate), the Agencies have elected to use a “daily compounded in advance” convention for their loans. The floating index for the loan will reset at the beginning of the interest period, much like most LIBOR loans currently do. For the index itself, Agency SOFR-indexed loans will reference the 30-day compounded SOFR rate as published by the Federal Reserve Bank of New York on the business day preceding the first day of the interest period. The use of a 30-day compounded rate addresses the concerns market participants have over SOFR’s volatility – use of a 30-day rate smooths out this volatility, as seen in the graph below. It is also interesting to note that this results in interest expense for a given period being based on observations of SOFR over the previous period.

Closing an Agency ARM typically requires a purchase of an interest rate cap to establish a max note rate for underwriting purposes. As the Agencies move to transition to SOFR loans, the common question we’ve been getting from borrowers, originators, and our partners at the Agencies is whether SOFR caps will be available at commercially reasonably prices for borrowers seeking to avail themselves of Agency ARMs. We are cautiously optimistic that this will be the case. While liquidity and availability for SOFR caps is still quite thin, we expect this to begin to change over the next one to three months. As of this writing, we know of three cap providers that are willing to sell SOFR caps, and have spoken with two more that hope to be able to offer them by the end of August. This group includes most of the Agency-approved cap providers. Yet another Agency-approved provider has indicated that they expect to be able to offer them in September. At the outset, we expect pricing for SOFR caps to be higher than similarly structured LIBOR caps, as the reduced liquidity makes it harder for banks to lay off their risk when they sell caps. Given the current low absolute level of pricing for caps and the fact that required strike rates on Agency ARMs tend to be in excess of current LIBOR, this anticipated shorter term SOFR premium is not likely to have a meaningful impact on deal underwriting. To emphasize this, we have included some side-by-side indicative cap pricing for LIBOR and SOFR caps with similar structures for a hypothetical $25 million loan.

It is also worth noting that Freddie Mac is permitting, for a short time, the use of LIBOR caps on SOFR-indexed loans, subject to some conditions and restrictions. This will provide a backstop to Freddie floating-rate borrowers if SOFR caps are not available under commercially reasonable terms. Based on our expectations for the SOFR cap market and the requirements associated with use of a LIBOR cap, this approach likely will not be the most economical approach for borrowers.

Chatham will continue to monitor the Agency ARM market and the availability of SOFR caps as the Agencies continue to transition from LIBOR to SOFR, and we will post updates as we see relevant developments. In the interim, if you need a quote on a cap for an Agency financing (whether based on LIBOR or SOFR) or have any other questions, please feel free to reach out to your Chatham representative.