Q1 2023: State of the Market with Co-Founder and Principal, Michael Becker

Q1'23 State of the Market

Written by Michael Becker
Q1 2023 Newsletter

Michael Becker Here...

As the winter season comes to an end and spring is now upon us, at SPI Advisory, we’re doing a bit of "Spring Cleaning" ourselves. Although we started this process a long time ago, we’re just now on the tail end of accomplishing a complete reposition of our apartment portfolio. "As I discussed in the Q4'22 Newsletter," back in 2017, we set out to sell our older workforce housing assets as the cap rate spread between Class A & Class B/C properties converged and fundamentals no longer supported buying older assets. At one point in time, SPI had dozens of workforce housing properties in our portfolio… but, today, only 3 remain, which we intend to hold long term due to their superior performance.

Part of our "Spring Cleaning" also includes refinancing & reinforcing the capital structures of our current assets to ensure that we’re able to easily transition back to riding the tailwinds of the capital markets once rising interest rates start to show signs of decline. As of recent, we’ve successfully completed several refinances and have additional refinances either actively in process, or under strong consideration.

Let me expand a bit on our thought process behind this . . .

At the onset of our career, in 2013/2014, we exclusively financed our portfolio with 10-year fixed-rate agency debt (Fannie/Freddie). At the time, we thought it was a great idea to get 10-year fixed rates in the low-5’s with 1-year of interest only ("IO") followed by 9 years on a 30-year amortization with a loan that was assumable. Then, we found out that there was the option of a 12-year fixed rate with 3 years of IO, so we signed on a ton of those. In hindsight, we thought that this debt structure would be accretive to us when we went to sell, as we expected the buyer would see the loan as an asset and pay up for the right to assume it. However, as 10-year treasury rates fell over the years to a striking 0.5% in August 2020, the exact opposite happened.

All those loans came with a Yield Maintenance prepayment structure, an equation that essentially protects the lender’s interest by placing the responsibility of lost interest income on the borrower.

YIELD MAINTENANCE = Present Value of Remaining Payments on the Loan X (Interest Rate - Treasury Yield)

In a nutshell, there are two standard components that determine Yield Maintenance premiums, the first being time: as a loan approaches maturity, the Present Value ("PV") of the remaining loan payments decreases, and therefore, so does the prepayment penalty. The second factor contrasts the loan’s interest rate to the comparable market treasury rate: if current treasury rates are lower, your prepayment penalty will be higher, and, conversely, if treasury interest rates are higher, the prepayment penalty will be lower. The lender must replace that income stream to make them whole, so the lower the interest rates, the more bonds they need to purchase to equal the same income stream, and, conversely, if rates are higher, you can purchase fewer bonds to replace that income stream.  

As a direct result of the lending decisions that we made early on, we ended up paying 10s of Millions of dollars in Yield Maintenance to pay off the loans for the deals that we sold in 2015-2021, the worst of which was 23% of the total mortgage balance. While at the end of the day we were still able to produce exceptional returns for our investors on these deals, in my mind, these experiences revealed that the phenomena of “knowing” and “understanding,” while similar, are not the same… Both are distinct mental states involving different forms of cognitive grasp: “knowing” is passive and refers to the recollection of discrete facts, while “understanding” is active and describes the ability to assign meaning and context to those facts to form the big picture. In 2013, I knew what Yield Maintenance was, but today I truly understand what Yield Maintenance is.

I say all of this to provide you with some context on how we’re strategizing our approach to the refinances that we’re currently pursuing, because taking on a 10-year fixed rate isn’t as much of an “obvious choice” as it used to be simply due to the prepayment structures attached. Today, we have a variety of debt on the multifamily assets we own, both floating & fixed. Most of our deals have longer-term maturities, even if they float, however, we do have several maturing before the end of 2023. We’re taking somewhat of a “mixed bag” approach, but, in general, we’re seeking middle-ground solutions. Below are some examples of the tactics we're employing:

In February of this year, we closed on two refinances of existing Freddie Mac "Floaters" that we took on back in August 2020. We had plenty of term left on these loans, however, the interest rate cap that we purchased was set to expire in September 2023 and would’ve been more expensive to repurchase then. So, in December 2022, we signed the terms for a refinance going floating to floating with Freddie Mac. The main benefit of this refinance was being able to:

Lower our loan spread from the high-2’s over LIBOR to the low-2’s over SOFR,
Purchase a 2-year high-2’s rate cap for an all-in rate of 5%,
Increase monthly cash flow which had previously been depleted by escrows as a result of the lender increasing the max strike rate on the replacement cap they escrow for up to ~5%,
Cover the refinance transaction cost as the new loan amounts were higher than the old loans, & 
De-risk our deals by taking the interest rate risk off the table for 2 years into Q1 2025, which we believe is more than enough time to get to the backside of the current Federal Reserve tightening cycle. (Of course, time will tell if this is correct or not).  