How Are CMBS Loans Priced?
CMBS loans are priced by taking the appropriate swap or Treasury rate and adding a credit spread, which compensates the lender for their risk and the work they do during the loan application and underwriting process. CMBS loan pricing also depends on the potential default risk of a specific loan, which varies due to factors including LTV, DSCR, property type, and loan term. Higher leverage, low DSCR, and longer-term loans typically have the highest interest rates, while lower leverage and shorter-term loans typically have lower rates.
It should be noted that floating-rate CMBS loans are often priced at lower rates than fixed-rate conduit loans, particularly when interest rates are rising. This compensates the borrower for the potential rise in interest rates by giving them a lower interest rate at the closing of the loan.
Treasury Rates and Swap Rates in Relation to CMBS Pricing
Many CMBS loans are priced based on the U.S. Treasury rate for the specific period of the loan’s term. For instance, a 10-year CMBS loan will be based on the current 10-year Treasury Rate plus a credit spread.
However, some loans are based on the Swap rate, the fixed rate that the swap "receiver" demands in exchange for the uncertainty of having to pay a short-term rate. This swap rate itself is based on either SOFR (Secured Overnight Financing Rate), or LIBOR (London Interbank Offering Rate). These are the interest rate levels that banks use when they lend money to each other for very short periods of time, sometimes just overnight.
What Else Impacts CMBS Pricing?
A few other variables that affect CMBS pricing include:
Loan Term/Maturity: The longer the term of a CMBS loan, the riskier it is for the lender, as more time means more default risk. Therefore, 5, and 7-year CMBS loans, all other factors held the same, typically have lower interest rates than 10-year conduit loans.
Quality of Asset/Borrower: The quality of the specific property and the financial strength of the borrower may also influence the pricing of a CMBS loan. Higher-quality properties in better neighborhoods and larger markets will generally receive lower interest rate pricing. Likewise, borrowers with a high net worth and lots of liquidity (particularly institutions) may receive a more favorable rate than less financially strong borrowers.
CMBS Risk Retention Requirements: After the crash of 2008, part of which was influenced by reckless CMBS lending, the Dodd-Frank Act of 2010 was implemented to reign in loose lending guidelines and increase lender responsibility. To do this, conduit lenders are now required to hold 5% or more of every CMBS loan they issue on their balance sheet for a minimum period of 5 years. This means lenders will lose money if a borrower defaults, and has generally led to slightly higher CMBS rates across all property types.
Default Rates: The default rate of CMBS loans varies by property type, with the highest default rates typically coming from hotel CMBS loans, with single-tenant net lease properties also suffering from high default rates. In general, property types and borrower profiles that have had higher default rates in the past will generally face higher CMBS loan rates, as lenders want to price in the additional default risk of these borrowers.