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CMBS Spreads: What You Need to Know
A CMBS spread, also referred to as a CMBS credit spread, is the difference between the interest rate of a CMBS loan and the underlying index on which the interest rate is based on. Since the vast majority of CMBS loans are based on the swap rate, spreads can usually be determined by taking the interest rate of a loan and subtracting the swap rate.
CMBS Spreads: The Basics
A CMBS spread, also referred to as a CMBS credit spread, is the difference between the interest rate of a CMBS loan and the underlying index on which the interest rate is based on. Since the vast majority of CMBS loans are based on the swap rate, spreads can usually be determined by taking the interest rate of a loan and subtracting the swap rate. Spreads compensate a lender for their risk, as well as providing for some of the profit that the lender will make as a result of the CMBS transaction. Increased spreads also mean increased profits (and risks) for CMBS investors.
CMBS Spreads Are Impacted By Several Economic and Financial Factors
Several major factors impact CMBS spreads, including:
Borrower/Asset Quality: Commercial mortgage backed securities composed of Class A office properties in large metro areas (i.e. New York, Los Angeles) will have much tighter credit spreads than securities composed of Class B hotel properties in medium-sized markets.
CMBS Maturity: If a CMBS bond has a longer maturity, it’s considered riskier, as there’s a significantly higher chance that one or more borrowers will default on their loans during that time period.
U.S. Treasury Rate Fluctuations: Since the spread is simply the difference between the CMBS rate and the U.S. Treasury rate at the time, if the U.S. Treasury rate changes, so will the credit spread, all else staying equal. Economic certainty typically leads to higher U.S. Treasury rates, as fewer individuals want to purchase them, while uncertainty leads to lower rates.
What is a CMBS spread?
A CMBS spread, also referred to as a CMBS credit spread, is the difference between the interest rate of a CMBS loan and the underlying index on which the interest rate is based on. According to Multifamily.loans, since the vast majority of CMBS loans are based on the swap rate, spreads can usually be determined by taking the interest rate of a loan and subtracting the swap rate. According to CMBS.loans, a CMBS credit spread is defined as the difference in yield between a U.S. treasury bond and a specific commercial mortgage backed security.
How do CMBS spreads affect commercial real estate financing?
CMBS spreads can have a significant impact on commercial real estate financing. The spread is the difference between the CMBS rate and the U.S. Treasury rate at the time, and is impacted by several economic and financial factors, such as inflation, economic uncertainty, bond maturity, and borrower/asset quality. For example, CMBS bonds composed of Class A office properties in large metro areas will have much tighter credit spreads than securities composed of Class B hotel properties in medium-sized markets. As a result, the interest rate on the loan will be higher for the Class B hotel properties than for the Class A office properties.
What factors influence CMBS spreads?
A variety of factors can affect CMBS credit spreads, and, as a result, CMBS loan interest rates. These include:
- Inflation: Changes in inflation can affect market-wide supply and demand, which can have a trickle-down effect on CMBS loan rates/spreads. Source
- Economic Uncertainty: If the economy begins to falter, investors may begin to flock to U.S. treasury bonds, driving down their rates, and therefore increasing the difference between treasury bond and CMBS yields. Source
- Bond maturity: Credit spreads are typically larger for bonds that have longer maturities, as this increases the amount of risk for potential borrowers. Source
- Quality/rating: Commercial mortgage backed securities composed of loans taken out by higher risk borrowers will naturally have a larger credit spread than those composed of lower-risk loans. Source
- Borrower/Asset Quality: Commercial mortgage backed securities composed of Class A office properties in large metro areas (i.e. New York, Los Angeles) will have much tighter credit spreads than securities composed of Class B hotel properties in medium-sized markets. Source
- CMBS Maturity: If a CMBS bond has a longer maturity, it’s considered riskier, as there’s a significantly higher chance that one or more borrowers will default on their loans during that time period. Source
- U.S. Treasury Rate Fluctuations: Since the spread is simply the difference between the CMBS rate and the U.S. Treasury rate at the time, if the U.S. Treasury rate changes, so will the credit spread, all else staying equal. Economic certainty typically leads to higher U.S. Treasury rates, as fewer individuals want to purchase them, while uncertainty leads to lower rates. Source
What are the benefits of CMBS financing?
CMBS loans offer a variety of benefits for commercial real estate borrowers, including flexible underwriting guidelines, fixed-rate financing, and fully assumable loans. Additionally, lenders and bondholders can potentially achieve a higher yield on investments, and investors can choose which tranche to purchase, allowing them to work within their own risk profiles.
For more information, please see The Pros and Cons of CMBS Loans: A Guide and CMBS loans in Apartment Investing.
What are the risks associated with CMBS financing?
CMBS financing can provide a high leverage loan for properties in secondary and tertiary markets, but it can also provide a poor loan servicing experience with significant prepayment penalties. Other risks associated with CMBS financing include:
- Less autonomy in the operation of the property and limited flexibility to deviate from the terms of the loan documents.
- Difficulty in releasing collateral.
- Expensive to exit.
- Lock outs often prevent prepayment or up to two years.
- Reserves required.
- Secondary financing (i.e. mezzanine debt or preferred equity) not always allowed.
For more information, please see The Pros and Cons of CMBS Loans: A Guide and Multifamily CMBS Loans.
How can I get the best CMBS spread for my commercial real estate loan?
The best way to get the best CMBS spread for your commercial real estate loan is to ensure that your loan meets the criteria that CMBS lenders look for. This includes having a low Loan-to-Value (LTV) ratio, a desirable property location, strong tenant strength, a shorter loan term, a larger loan size, staggered lease terms, an asset class/asset type that is less risky, a higher Property Cash Flow (DSCR), and a high-quality asset. Additionally, economic conditions can also affect CMBS spreads, so it is important to be aware of the current market conditions.
For more information, please see the following sources:
CMBS Credit Spreads Are Also Increased As A Result of Dodd-Frank
CMBS loans boomed before the 2008 financial crisis— as lenders had extremely lax requirements and spreads were incredibly low. Unfortunately for everyone involved, the CMBS market crashed along with the rest of the real estate market, leading to serious issues for both borrowers and lenders alike. However, many lenders were unscathed, as they were, at the time, permitted to offload 100% of their CMBS loans to investors. The Dodd-Frank Act of 2010 changed all this by requiring lenders to keep at least 5% of a CMBS loan on their books for at least 5 years. The rule is intended to ensure that lenders choose borrowers more carefully, by ensuring that they will face financial consequences if the borrower defaults. Naturally, this has also lead to an increase in CMBS spreads, as lenders want to be compensated for their increased risk.