CMBS Credit Spreads are Based on a Variety of Factors
CMBS credit spreads are defined as the difference between the appropriate swap or Treasury rate and the interest rate of the CMBS loan. CMBS loan pricing is based on the current swap rate or U.S. Treasury rate plus the credit spread, which compensates the lender for the risk of providing the loan to the borrower.
Swap rates are based on LIBOR (London Interbank Offering Rate) or SOFR (Secured Overnight Financing Rate), which are the rates that banks lend to each other for extremely short-term loans. Alternatively, CMBS loans may be based on the current rate of the appropriate length U.S. Treasury rate plus a credit spread.
In addition to the swap or Treasury rate, CMBS credit spreads, and hence interest rates, are based on a variety of factors, including LTV, DSCR, property type, and loan term. Pricing is based on perceived default risk, and properties with lower LTVs, higher DSCRs, and shorter terms generally receive lower interest rates.
CMBS loans issued for less risky property types, such as multifamily and industrial assets may also be priced lower than properties that are perceived to be riskier. Riskier asset classes may include hotels, assisted living, healthcare properties, or more exotic property types, like parking lots or marinas.
In addition, floating-rate CMBS loans, which are somewhat rare, may be priced at lower rates than fixed-rate conduit loans, particularly in an environment of increasing interest rates.
Other Factors Impacting CMBS Credit Spreads
Other factors impacting pricing and credit spreads include:
Asset/Borrower Quality: In general, Class A properties in major MSAs, such as New York or Miami, will get lower pricing, while Class B or Class C properties in smaller markets will be priced higher. While CMBS loans generally have low net worth and experience requirements for borrowers, borrowers with a higher net worth or more real estate experience may receive lower rates. Brand name real estate investment firms or hotel brands may get additional rate reductions.
Loan Term/Maturity: CMBS loans with longer terms are generally priced higher, as there is more time for the loan to potentially default before it’s repaid. For example, a 5-year CMBS loan will generally have a lower interest rate than a 7 or 10-year conduit loan.
Swap, LIBOR, SOFR, and Treasury Rates: Credit spreads, as previously mentioned, are the difference between the interest rate of a CMBS loan and the appropriate interest index that it’s referenced against, whether LIBOR, SOFR, or U.S. Treasury rates. Economic volatility generally leads to higher interest rates due to the uncertainty of repayment.
Default Rates: Default rates, also known as delinquency rates, also impact credit spreads and conduit loan pricing, as spreads generally increase when more borrowers default on their loans. For example, in Q4 2020, the U.S CMBS delinquency rate was 8.2%, while by mid-2021 it had fallen to 6.2%, and by Q4 2021, it had fallen to 4.1%. Loan pricing and credit spreads fell during that time, particularly for less-risky property types such as multifamily and industrial assets.
The Dodd-Frank Act, Risk Retention and CMBS Pricing
The crash of the real estate market in 2008 resulted in massive CMBS loan defaults and huge losses for CMBS investors. Many lenders, however, were not harmed, as they had already sold their entire CMBS loan portfolios to outside investors. To ensure lenders underwrite and originate loans responsibly, the Dodd-Frank Act of 2010 implemented risk-retention rules for CMBS lenders.
This means that CMBS lenders now must hold onto at least 5% of all issued CMBS loans for a minimum of 5 years post-origination. This aligns the interests of lenders and investors, as lenders will lose out if a borrower defaults on their loan. Risk-retention is another factor that increases CMBS pricing and spreads, as it increases lender risk, and lenders naturally want to be compensated for any additional risks they take on.