by Brandon Miller, Senior Director
“When can I lock in my rate?” or some variation of this question is without fail one of the first asked by a Borrower upon executing a CMBS loan application. At the time of application, the lender offers the borrower an interest rate based on a “Spread” over a selected benchmark index – for purposes of this discussion we will use the 10-year Treasury. During the application process and before the loan is rate locked the Borrower is taking interest rate risk and will typically keep a close eye on the movement of Treasury yields. Swings downward in the yield often solicit calls from the Borrower to initiate an early rate lock while swings upward can cause some trepidation. This holds especially true in a low and/or falling rate environment where the ability to lock a rate early and quickly becomes magnified.
While a rate lock agreement does reduce a Borrower’s exposure to changing interest rates and helps to solidify the final loan amount, most Borrowers are unaware that it does not completely eliminate the risk of future change in rate prior to or at closing. As previously mentioned, the interest rate for a CMBS loan is based on an index, such as the 10-year Treasury, plus a Spread. When a Borrower enters a rate lock agreement, the Lender is agreeing to lock in the prevailing rate of the benchmark index by purchasing a hedge instrument to protect against fluctuations in the yield. However, the Borrower still has exposure to changes in the Spread. Typically, rate lock agreements for CMBS loans are entered within a matter of days before the loan is actually closed so the exposure to changes in Spread is very limited. In a stable market, it is rare that a Spread change would occur after rate lock as evidenced historically in CMBS 1.0. However, in today’s volatile and uncertain economy, the Borrower continues to be at risk to Spread changes up until the point the loan is closed.
2011 has been a roller-coaster ride in the CMBS industry as many expected. More and more lenders have launched CMBS platforms and as early as March, we started to see indications of an improving market and less stringent underwriting standards. But just as quickly as this rise occurred, we have witnessed the reigns pulled back in during the Summer of 2011. Tumultuous debt markets in the United States and abroad, high unemployment levels, fears of a double-dip recession, etc. have all led to volatility and uncertainty in the CMBS market. Two large CMBS pools went to market in July and received poor reception from Buyers causing Spreads to widen by at least 25-30 basis points overnight. We have seen similar transactions that were quoted with a spread in the low 200’s in March or April now be quoted in the low 300’s – a 100 basis point swing in the matter of 60 to 90 days.
Borrowers, Lenders and Brokers must communicate closely over the course of the application period. Typical CMBS loans will take at least 45-60 days to close. Many times the loan application is signed 7 to 10 days after it is issued so the quoted interest rate and spread are already a week old. As we are seeing today, dramatic swings in Spread can happen overnight. No one would welcome a surprise change just days before closing especially with so much time and money invested in securing a CMBS loan. That said, a CMBS loan offers a viable financing alternative where other options may be limited. Clearly it is better for all parties to enter the transaction with realistic expectations and with all cards on the table – especially with regards to a Lender’s ability (or willingness) to lock the interest rate.
Want to learn more? Contact Brandon Miller, Senior Director.