Securitized commercial mortgage-backed securities—such as Freddie Mac K-Series certificates—tend to be less transparent than traditional equity investments. While buy-side credit fund managers receive sufficient information to make informed decisions to invest in CMBS bonds, not all information is readily available for investment transactions, and individual investors are typically only presented pool-level performance metrics and collateral characteristics rather than asset-level information for securitized products within a fund. Because of that, it’s worth discussing three key factors shaping investment strategies around Freddie Mac-originated debt and more broadly, the CMBS space: SOFR, refinance risk and borrower financial health.
SOFR increases: The commercial real estate bond market has navigated a challenging landscape throughout 2023, primarily driven by the significant uptick in the 30-day SOFR, which escalated from 4.13% on Jan. 3 to 5.33% as of Nov. 30. That’s compared with the troughs of 0.01% on April 14, 2021. The monthly payments on floating rate notes are determined by the current SOFR plus the loan’s margin, or spread—the difference between SOFR and the lender’s borrowing rate. As SOFR changes, so do the monthly payments for floating rate loans.
When SOFR increases, the implications can be stark: The monthly, interest-only payment on a $20 million loan indexed solely to SOFR (assuming zero spread), escalated from $69,789 in early January to $90,067 by late November. Assuming net operating income is constant, debt service coverage ratio, or DSCR, on that loan fell to 1.08x by November from 1.40x in January. Freddie Mac generally sizes fully interest-only loans to a 1.40x DSCR. For loans whose DSCRs are lower than that at refinancing, the borrower must provide additional equity, referred to as a cash-in refinance.
SOFR, January 2021 to November 2023
Source: Federal Reserve Bank of New York
Freddie Mac-originated floating rate notes have interest rate caps that serve as a hedge against rising rates and allow the borrower to calculate the worst-case-scenario DSCR, assuming all else is equal. However, these caps are time-bound, and the cost of repurchasing at expiration escalates if SOFR rises. At a minimum, borrowers are required to make monthly payments into a reserve account, equal to 125% of the cap renewal cost, by the cap’s expiration date. If the property isn’t cash flowing, the borrower must fund this reserve account from liquid accounts—which points to the importance of the borrower’s financial health.
Refinancing risks in fixed-rate loans: Fixed-rate loans are insulated from SOFR increases until it comes time to refinance in a high-interest-rate environment. Credit fund managers must analyze metrics such as refinance loan to value, or LTV, debt yield and DSCR to determine the most likely scenario at refinance. Those scenarios include requiring a cash-in or cash-out refinance, a sale or the elevated probability of default. This stress testing is especially important for loans originated at lower index rates and peak pricing from Q2 2021 through Q2 2022.
Borrower health: Factors such as falling revenue, rising expenses and higher lending costs are increasingly requiring borrowers to inject equity in underperforming loans, so it’s essential for credit fund managers to thoroughly assess borrowers’ financial health. This involves comparing net worth and liquidity against outstanding loan balances. Generally, an adequate financial position means net worth and liquidity multiples exceed 1.0x and 0.10x, respectively. Borrowers falling below these thresholds may be deemed higher risk, as they may struggle to cover payments for underperforming assets or lack the funds for necessary property improvements.
However, a comprehensive risk assessment goes beyond just these financial metrics. It also includes evaluating the health of the borrower’s entire real estate portfolio. Credit fund managers will often review a REO (real estate-owned) schedule to analyze the performance of the borrower’s other real estate holdings. A borrower with robust financials but a portfolio of stressed properties might pose a higher risk than one with limited liquidity but a well-performing portfolio.
Although SOFR has continued to climb over the past two years, there is no guarantee it will continue to do so or that it will stabilize at current rates. Credit investors who believe SOFR will decrease in the short to mid-term may strategically weight their portfolio in favor of fixed-rate bonds, which can offer a hedge against yield erosion in lower-interest-rate environments. Additionally, fixed-rate bond market values may trade at premiums when market rates are below the bond’s coupon rate. Managers may also adopt more sophisticated strategies such as credit swaps or interest rate floors, instruments that provide a strategic hedge against a decrease in SOFR for floating rate bonds.
Managing a credit fund in the CMBS market requires fund managers to optimize current yield while assessing and adapting the portfolio to mitigate immediate and future risks. While the challenges posed by these three factors reflect the current state of the bond market, market conditions are dynamic as well, and credit fund managers must continuously identify and respond to the unique risks associated with each one.