Fixed Versus Floating

There may still be benefits to selecting adjustable-rate, not fixed-rate, mortgages.

By Keat Foong, Executive Editor  

As would be expected, the vast majority of borrowers are opting to lock in low interest rates for the long-term, now that interest rates are projected to become less favorable in the next 12 months. But there is still a significant minority of borrowers who are selecting mortgages carrying floating rates, even if they are planning to hold the properties long-term. So why are they opting for financing whose interest rates could bump up?

Lenders are reporting that some multifamily borrowers are in fact not fearful that interest rates are on the upswing—despite projections—and are seeking to save money by opting for the shorter-term mortgages. There are borrowers who are “still gambling that short-term rates will stay low enough that they can still save money in the short-term and have time later to lock in the long-term rates,” observes Larry Stephenson, executive vice president—regional manager of NorthMarq Capital.

Of course, adjustable-rate mortgages still compose a minority of mortgages taken out, as most borrowers are interested in locking in those extraordinarily, propitiously, low rates. Stephenson says that “the great majority” of NorthMarq’s loans are now for typical 7- to 10-year terms. “Most borrowers think rates will go up next year,” agrees Brian Sykes, senior vice president, Capital One Multifamily Finance.

Indeed, economists are for the most part calling for higher rates. The Mortgage Bankers Association (MBA) forecasts that interest rates for the benchmark 10-year U.S. Treasury bond yield will begin increasing to 2.8 percent by the end of this year, and to 3.3 percent by the end of 2015. “What we have seen is that there is a whole range of forecasts. But the expectation is fairly consistent that rates will increase. Rates have stayed low longer than most economists had anticipated,” says Jamie Woodwell, MBA vice president of research and economics.

It is the growing economy, Woodwell says, that will finally put upward pressure on interest rates. Woodwell cites GDP growth of 4 percent in the second quarter as one major signal of a firming economy. He also notes that for more than six consecutive months, employment gains have held above the monthly figure of 200,000 (150,000 is the level of job gains economists have said is needed to accommodate new entrants into the labor force). And the official unemployment rate has also dropped.

Nevertheless, there are still a certain number of apartment players who are skeptical that they will see ballooning interest rates in the next 12 to 18 months. “The fear of higher rates” among borrowers is, if anything, “diminishing rather than increasing,” says Stephenson. Many borrowers, he says, “are being lulled into complacency by the slow recovery and lack of inflation.”

Byron Cocke is the co-CEO of Cocke Finkelstein Inc. and CFLane, an Atlanta-based real estate and investment firm that owns about 11,000 units and manages a total of 40,000 units in the southern and central U.S.  Byron indicated that it remains unclear whether interest rates will rise or fall in the near term, noting that factors which may influence domestic borrowing include Treasury rates in international markets—especially in Germany and Japan, where 10-year Treasury rates are lower than in the U.S.

As an apartment borrower, Cocke’s company bases its decision on whether to opt for fixed or adjustable rate mortgages on the property’s expected holding period and business plan. If the intention is to keep the property for more than 10 years, a fixed-year mortgage will be selected.  If the company plans to refinance or sell the property in a few years, it will consider an adjustable-rate mortgage, says Cocke.

But other companies may resort to adjustable rate even when the hold is long-term. If there is little fear of sharp increases in rates, adjustable-rate mortgages are attractive for borrowers because of the lower interest rates they carry compared to their fixed-rate counterparts. “Floating rates continue to be low, with the current effective rate a little over 2 percent,” says Sykes. While the interest rate on fixed-rate mortgages is in the high 3 percent range, about 3.9 percent, says Stephenson, “floating rate on the same property can be as low as 2.25 percent,”—almost a 2 percent difference.

Furthermore, 10-year floating-rate mortgages may allow for penalty-free prepayment. Fannie Mae and Freddie Mac adjustable-rate senior loans have a one-year lock-out followed by a 1 percent prepayment penalty. However, the 1 percent prepayment penalty is waived if the loan is converted to a fixed-rate loan with the same lender, Sykes explains. As far as timing, Fannie Mae adjustable-rate mortgages can generally be converted to a fixed-rate mortgage with about two weeks’ notice, says Sykes, and “most other ARMs can be converted to fixed rate within 30 days.”

The ability to prepay the adjustable-rate mortgages gives borrowers the chance to obtain a floating-rate mortgage, and switch to a fixed-rate “relatively quickly and at very little cost” if and when they see interest rates rise, says Sykes. Borrowers can also use the cash flow obtained as a result of carrying the lower rate “to add value to their properties through renovation projects,” he adds. Provided interest rates don’t rise too sharply and suddenly, borrowers will only have lost the chance to lock in moderately lower fixed rates earlier in the game.

Additionally, many borrowers may be taking advantage of the lower floating rates to acquire properties with low cap rates. “We see a lot of buyers justifying high prices with floating-rate financing—though if it takes a floating rate to justify your investment, you may not want to [proceed with the acquisition],” comments Cocke.

Make no mistake, most long-term permanent financing obtained is still fixed-rate. Year to date, only about 2.5 percent of NorthMarq’s financing (in loan dollars) are closed on a floating-rate basis, says Stephenson. Most borrowers who are obtaining financing for the long-term would want to fix in low rates for as long as possible.

And Stephenson reports that most borrowers are asking for 10-year fixed-rate mortgages because the price goes up substantially for fixed-rate terms longer than 10 years. (A longer-term loan carries more risk for the lender.) A 15-year life-company fixed-rate mortgage, for example, carries interest rates that may be about 50 basis points higher.

Life companies supply balance-sheet based fixed-rate mortgages with terms of 12, 14, 15, or 20 years, and these tend to be very customized financing, says Stephenson. Freddie Mac also offers 12- or 15-year terms, but it does not pursue loans with these terms very aggressively, he adds.

Among borrowers expecting interest rates to increase, forward rate-locks are currently in demand, says Sykes. Borrowers with soon-to-be maturing loans that still carry prepayment penalties can lock in  rates for their new loan as far as 12 months in advance. Currently,  the cost to forward-rate lock a loan for six months is about 23-30 basis points, which is added to loan spread. “Given Treasuries can move 15-20 bps over a few day this additional cost can be considered good insurance,” says Sykes.

On the other hand, borrowers are also prepaying existing loans to cement long-term low-rate financing. And they are even willing to pay prepayment penalties to do so, notes Sykes. “This can make economic sense, especially if there is an opportunity to recapture additional equity in the properties through a refinance,” he says.

The major providers of fixed and adjustable rate mortgages are the GSEs, life insurance companies and CMBS conduits. But, of late, banks are also getting into the long-term financing game. Traditionally, banks supplied three- to four-year loans, but “they are very much getting into longer-term financing including non-recourse,” says Stephenson.

As interest rates are projected to fall, borrowers have a variety of fixed- and adjustable-rate mortgage options at their finger tips. And some of them are figuring that adjustable-rate product still makes sense.

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