FEATURE ARTICLE, APRIL 2006
ARE LENDERS SPREAD TOO THIN?
The argument for tighter spreads and a reason to look forward.
I have recently read that there were lenders who invested two times their 2004 volume in 2005, but funded at one half their 2004 profit margins. The question was asked: is that a sustainable business model? My answer is that you can’t erode your margins in perpetuity and be very profitable, but it seems the 2004 market may have been a “little fat.”
Competition tends to tighten spreads. We all know that there is an abundance of capital in the marketplace pursuing all product types and in most locations at leverages up and down the capital stack. Advantage borrower — margins compress. But what happened in 2005, and what is happening currently, is that risk is being more efficiently priced. Competition has instigated structuring and technology innovations that allow tighter pricing, but also increase loan profitability.
Effective risk distribution is one of the elements leading to tighter pricing. With the advent of the super senior tranche having a 30 percent subordinated level, Wall Street is creating investment levels where each participant can feel comfortable in their pricing niche (and therefore attract additional capital to the real estate market). As we carve the capital stack into smaller segments, each can be appropriately risk-adjusted for pricing purposes. Furthermore, the reduced cost and increased use of CMBS synthetics and related credit derivatives such as credit-default swaps and total-rate-of-return swaps are tools that allow originators to lay off most of the risk of loan pricing before the loan is securitized. When expected returns can be hedged, risk is reduced and margins can be tightened. Later this year, investors will be able to further hedge their positions with the introduction of the CBMX Index. The Index has been designed to efficiently allow traders, originators and investors to take a position in the CMBS market as a whole.
Margins may have been reduced for lenders due to competitive forces, but the tools and techniques to manage risk and return help to keep lenders in control of their profitability and therefore sustain their business model.
Now for some practical stuff. To paraphrase, “Go forward young man.” If you think rates and/or spreads will increase by 10 to 24 basis points in the next 12 months and you will be in the market for permanent debt, tie that money up now. The inverted yield curve has made getting a forward commitment relatively cheap insurance against index or spread increases. CMBS lenders are adding between 1.5 and 2 basis points per month to go forward 12 months, with options to extend that for 3 more months. Life Companies are adding 0.8 to 1.25 basis points per month for up to 18 months. This “insurance” not only protects against higher rates, it also preserves maximum loan proceeds (for every 10-basis-point increase in the index or spread, loan proceeds are reduced by approximately 1 percent due to coverage constraints). Look ahead and check when loans open for prepay, when they are maturing or when your new development will reach 75 percent occupancy. If any of those events occur within 18 months call your favorite lender or mortgage broker and explore going forward.
Mark Strauss is the managing director for Cohen Financial in Newport Beach, California.
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