If you’ve been a long-time reader of our weekly blasts, you may recall an article from a year ago about cutting escrows on Freddie Mac deals in half. Borrowers with loans nearing maturity can eliminate escrows by purchasing a replacement cap through maturity—and in some cases, borrowers may even receive a part of their escrow balance back. Declining yields and lower cap costs make eliminating monthly escrows more appealing, especially now that markets have reversed last year’s surge in escrow costs caused by peak short-term yields and servicer recalculations.
Freddie Mac loans originated in 2020 and 2021 benefited from historically low interest rates, which meant lower strike requirements. Many of these caps have already been replaced multiple times and are nearing another rate cap expiration, leaving borrowers at risk of new escrow requirements calculated against an expensive replacement.
2020 Case
For example, consider a loan that originated in March 2020 with a notional amount of $50mm. The average rate cap strike that year was around 2.00%. With a typical Freddie Mac loan term of seven years, maturity is approaching in 2027. Instead of purchasing a one-year rate cap extension, borrowers could opt for a two-year extension to align with the loan maturity, thereby eliminating escrow requirements entirely.
The table below provides an estimate of the current escrow reserve balance, the cost of a rate cap extending through loan maturity in 2027, and the potential excess escrow balance that could be returned.
Extending the cap through maturity, instead of the minimum one-year requirement, incurs an additional cost of $795K. However, by doing so, the borrower eliminates a monthly escrow contribution of approximately $49K for the next six months, allowing them to retain more liquidity through the loan’s maturity.
Below, we've outlined a comparison between the two scenarios and their costs. The first compares purchasing a replacement cap through maturity to eliminate the projected $49K monthly escrow versus purchasing 1-year rolling rate caps.
The right table shows that if the market follows rate expectations, the next 1-year cap is projected to cost approximately $850K once the first one matures. For you to be indifferent between purchasing a 2-year cap now or waiting until next year, rates would need to average ~20 basis points lower in the second year than current market expectations.
You might ask, “But what if I plan on refinancing or selling the property in a year or two?” No problem—a rate cap is an asset to you, meaning you unwind it and collect its current value once you close on the refinance or sale.
Assuming market expectations and volatility remain constant, the strike is projected to be in the money throughout the life of the hedge. As a result, you may receive funds back for the remainder of its term. If you had one year left on the cap, its projected value as of the time of this article would be $750K.
2021 Case
Next, let’s examine a case where a seven year loan was originated in 2021 with a strike of 2.50%, which was the average during that year. In this scenario, the borrower may have an out-of-pocket cost for the cap premium required to extend through the loan’s maturity in 2028 by purchasing a 3-year cap.
If your goal is simply to satisfy the lender’s requirement for a 1-year replacement cap, your new estimated escrow amount is shown in the left table below. We've also included the estimated escrow amount for a 2-year cap should you choose that option.
Depending on cash flow preferences and financial strategy, it could make sense to come out-of-pocket $225K now rather than paying ~$77K per month for the next six months and having a new escrow requirement thereafter. Paying upfront ensures cost certainty, while monthly escrow preserves liquidity.
If purchasing through maturity is less ideal, a 2-year cap with ~$15K monthly escrow for the next six months may make sense, avoiding an out-of-pocket expense for the replacement cap purchase while also reducing the monthly escrow. However, while it does not fully eliminate escrow requirements, it helps lower the monthly contributions from ~$77k to ~$15k, improving cash flow efficiency.
As with the 2020 case, if you were to purchase a cap through maturity (3-year), assuming market expectations and volatility remain constant, the cap is projected to have meaningful value that could be recouped if the property is sold or refinanced before maturity.
Depending on the specifics of your deal, purchasing a longer-term replacement rate cap may be a more strategic option than meeting the one-year requirement. If you have a rate cap replacement that you’d like us to analyze, we’d be more than happy to assist—just reach out to PensfordTeam@pensford.com or (704) 887-9880.
