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.
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.