Rates have dropped—should you consider refinancing?

This is especially true in the fixed-rate residential loan markets, in which call protection for the lender is not typical. Many of our clients consider the trade-offs of prepayment penalties and defeasance premiums in return for locking in a lower current rate and extending the fixed-rate duration. While not as intuitive, borrowers should consider refinancing floating-rate loans with embedded floors.

As the forward curve has become flat-to-downward sloping, common practice over the last 24 months in the debt fund/bridge lending space has been to include floors at or near where LIBOR was at time of origination. Many floors were placed as high as 2.5% and, in the last six months, floor levels have been commonly set at 1.75%. Chatham has observed a significant number of floating-rate loans that were originated in late 2018 and the first three quarters of 2019 that have floors at 2% or greater.

With the recent, dramatic downward move in interest rates, accentuated by the Federal Reserve’s 50 basis points emergency rate cut on March 3, these floors are well above current LIBOR (0.863% as of March 6, 2020) and even further above where the forward curve implies LIBOR will be in the coming months (roughly 0.50%). Access current rates and forward curves at Chatham Rates.

This has effectively converted many floating-rate loans to fixed at the floor level plus the spread. One of the more apparent advantages of floating-rate loans is prepayment flexibility. While many floaters do have lockouts for an initial period or fixed prepayment fees of up to 1%, floaters that were originated during the peak of loan floors are likely beyond the lockout period or will be soon. Chatham recommends that borrowers review their loan portfolios, and proactively evaluate loans with embedded floors that are not locked out and can be prepaid. Clients using Chatham Debt Management, our web-based solution created to organize, manage, and report on loan portfolios for real estate and infrastructure, can run a report to identify these potential loans.

In weighing the costs of terminating an existing loan, transaction costs for a new loan, and new spread and floor levels, it may very well be economically advantageous to refinance at this time. We recognize the steep drop in index rates is certain to have a significant impact on credit spreads across the leverage spectrum, but it is too early to determine the magnitude of that impact. It is also possible that lenders may be willing to renegotiate floor levels and spreads in existing loans if faced with the alternative of an earlier than expected refinance. At the very least, this is worth a conversation with your lender.