CMBS conduit loan spreads have increased steadily this fall and many conduit borrowers who have not completed transactions recently are surprised when they receive a Term Sheet reflecting current market spreads. A natural response is “Wow, why is this loan spread so high compared with my last deal?”
First, let’s talk about why the loan spread is important. CMBS conduit loan interest rates are fixed for the life of the loan at closing by adding two indexes together: the loan spread listed in the Term Sheet and the swap spread. The swap spread has been relatively stable over the past four months at 2.00%-2.30%, and is now 2.13% for a 10-year CMBS conduit loan.
The loan spread reflects the spread that dealers sell CMBS securities to investors backed by CMBS conduit loans. CMBS conduit loan originators must charge the borrower a spread that is more than the spread offered to CMBS bond buyers in order to make a profit. As 2015 progressed, CMBS bond buyers demanded more spread to buy CMBS securities. Borrowers can follow this trend by looking at the AAA (10-year) CMBS securities spreads in the chart below; it is not an exact relationship, but roughly a 1-basis-point (bp) increase in AAA (10-year) CMBS spreads equates to a 1 bp increase in loan spread to borrowers:
(10 Yr. Spread,
The chart indicates a roughly 50 bp jump in AAA (10-year) CMBS spreads from May until November. So a borrower who may have closed a loan in spring 2015 and earlier at a loan spread of 250 bp that was prevalent at the time would now receive a Term Sheet reflecting a loan spread of approximately 300 bp.
… And What About a Projection on Loan Spreads for 2016?
As shown above, AAA (10-year) CMBS spreads have been trending up for many months. Initially, CMBS conduit loan originators held loan spreads to borrowers unchanged and accepted less profit, anticipating that the rise in AAA (10-year) CMBS spreads would reverse course. In addition, competition for CMBS conduit loans was fierce, and CMBS conduit loan originators did not want to lose loans to competitors. But by fall 2015, CMBS conduit loan originators began to lose money as AAA (10-year) CMBS spreads became greater than the loan spread on the underlying CMBS loans. In October and November, CMBS conduit loan originators raised spreads at a fairly rapid pace into last week.
The prospects for AAA (10-year) CMBS in the first half of 2016 may be a tug between two forces. Market professionals attribute much of the spread widening as driven by too much CMBS supply at yearend, when most investors have little remaining un-invested cash to buy CMBS securities. With fresh cash allocations for 2016, some bond dealers believe spreads will tighten. On the other hand, there are headwinds in the broader debt markets. With the unrelenting fall in the price of oil, exploration and development companies are beginning to default on their mostly junk-rated bonds. While one might ask “what do bonds related to oil-drillers have to do with commercial real estate?” cracks in one sector of the debt market can infect other sectors, as investors begin to take losses and become more risk averse across all debt markets.
Oddly, the likelihood that the Federal Reserve will increase short-term interest rates in 2016 may not be a factor in loan spreads; however, it could potentially impact swap spreads. “Despite the Federal Reserve increasing short-term rates, I don’t believe long-term rates (i.e., 10-year Swap rate and 10-year Treasury rate) will move much in the first half of 2016; I predict the current range of 2.0%-2.3% prevails,” said Michael D. Sneden, Executive Vice President at ValueXpress. That would mean interest rates to borrowers in the beginning of 2016 will largely depend on the appetite for CMBS securities.