The Case For Floating Rate Debt
In my last article, I talked about the not-so-popular topic of bridge loans. In this article, I’d like to discuss another often-feared topic, floating rate debt. In 2018, just like bridge loans, floating rate debt was considered cursed by many multifamily investors. The trope – “long-term, fixed rate debt” was and largely still is most investors’ financing flavor of the month. However, with the path of rates no longer certain to go to the moon, the ability to cap your interest rate exposure, and the cheaper prepayment penalty, floating rate debt is an interesting permanent financing option which is definitely worth considering for your next deal.
Pensford Financial put together a terrific fixed versus floating analysis last year backed by data, lots of data, so I won’t try to recreate what they have already done so well. Instead, I’ll give a quick summary. Historically, the market has overestimated the path of rates, specifically LIBOR, which implies that the cost of fixed rate debt is inflated by this overestimated future projection of rates. These results come with the added nuance that the market typically underestimates the path of LIBOR in a tightening cycle. This underestimation actually implies a huge benefit for floating rate debt, which is the fact that interest rate caps are priced based on the projection of future rates. So, when a cap is most likely to be needed, the market has generally underpriced the hedging product.
A peculiar example of a floating versus fixed scenario, which shows the power of floating, occurred in 2007 as the cost of fixed rate debt was actually less than floating. For example, on October 1, 2007, LIBOR was 5.23% and debt could be swapped to fixed at 4.66%, resulting in instant savings on your borrowed money. However, this time in history shows the dangers of fixing debt payments late cycle since “if the borrower remained floating, however, they ended up paying an average interest rate of just 2.50% because the Fed cut rates dramatically during the Great Recession.” Negative swap spreads occurred again for the first time since the aforementioned example in December of 2018. This could mean we are in for a downtick in rates and perhaps a recession is a lot closer than we all expect. To the contrary, the Fed has become increasingly more adroit/defter at managing the economy (minus Powell’s capricious comments which sent the market into a tailspin late last year) so maybe we are in-store for a soft landing. Nevertheless, here is a look at the historical success (or lack thereof) of choosing fixed rate debt over floating.
2-Year Swap
- Since 1990 it was only better to fix your floating rate debt via a 2-year swap 6% of the time. Furthermore, the maximum savings by fixing your rate for the next two years was 1.2% annually.
- Meanwhile, the maximum savings achieved by floating was 3.3% annually (almost three times as profitable!). This means that floating rate debt has an asymmetric risk/reward curve to the upside and a cap can be used to efficiently mitigate negative exposure.
5-Year Swap
- 8% of the time it was better to fix the rate using a 5-year swap.
- The maximum savings by fixing the rate was 1.0% annually over the next five years while the maximum savings by floating was 4.8% annually.
10-Year Swap
- Since 1990 it was never better to swap your floating rate debt using a 10-year swap.
- The maximum savings by floating was 4.7% annually over the next ten years.
What this all means is that the longer the term of investment, the greater the likelihood that floating rate debt will save money versus fixed. Even in the tightening phase of the cycle, an interest rate cap can be put in place to mitigate the pain of higher rates while retaining exposure to potentially lower rates. However, the potentially more important benefit of floating rate debt than the savings associated with a lower effective rate is the cheaper prepayment penalty.
Most sponsors’ underwriting (we have done this too, nobody’s perfect) doesn’t incorporate an accurate prepayment penalty into their exit costs. Typically, sponsors use a simple 1% to 3% gross cost of exit based on the sale price. The implication may be that the sponsors will sell the property on an assumption basis. However, since most of us underwrite to a five-year exit, the likelihood of selling on an assumption basis for 75% LTV agency-financed, value-add deals is extremely unlikely. For example, if you bought a property with 75% LTV with the plan to increase the value, the assumed sale price in the underwriting would reflect an extremely low assumption LTV to the future buyer, which is obviously unattractive. Additionally, a five-year investment is typically financed by 7 to 10-year paper which, when at a fixed interest rate, carries an expensive prepayment penalty such as yield maintenance, defeasance, or step-down. These forms of prepayment can result in a cost of more than 10% of the original loan balance! The example below is a 10-year $1,000,000 loan at 5% interest and 30-year amortization, which is prepaid at the five-year mark, assuming yield maintenance. The result is a very steep penalty which would discourage a sale from happening unless the future buyer were interested and able to acquire the property with a supplemental or second mortgage.
Source: Chatham Financial
Even a step-down structure, a less severe form of prepayment penalty, can still cost 4% to 3% to exit early and carries a higher interest rate (most of those low and attractive debt quotes come with yield maintenance while the interest rate for the same loan with a step-down prepayment schedule would be 20 basis points more expensive).
Meanwhile, the cost to exit permanent, floating rate debt is typically 1% of the existing loan balance. This provides great flexibility to the owners of the investment and it empowers them to sell when the market dictates, not when prepayment penalties do. Furthermore, the ability to refinance once the interest-only period of the loan runs out allows an investor to virtually never amortize their debt, thus maximizing cash flow. And just like fixed rate debt, the loan duration can be 10 years which is certainly enough time to ride out any bad times in the market.
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