October 30, 2001

Commercial Mortgage:
Swap Spreads Explained

The events following September 11th have led to 100 bps decrease in the cost of Fed Funds, $200 billion in increased spending, and lowered finance commercial mortgage costs overall. These factors combine to create a fairly significant stimulus package and the outlook for economic recovery in the second half of 2002 is looking more and more promising.

However, we feel pretty certain that the commercial mortgage lending practices of the last twelve months will not be the same as those for the next twelve. The capital markets are adjusting in anticipation of how bond investors will perceive future commercial mortgage backed securities issuance. These adjustments can be seen in the form of wider spreads and a second look at overall deal fundamentals that might give rating agencies reason to question the underwriting applied to a particular commercial mortgage. Commercial mortgage investors should continue to enjoy an ample supply of lending capital and competitive commercial mortgage interest rates, but should also be prepared for more conservative underwriting assumptions as they relate to items like rent concessions, overall vacancy, and line item expense increases such as insurance and utility costs.

Given the fluctuations in the marketplace, we're recommending an alternative approach to obtaining loan quotes that ensures the leanest quote a lender can offer. This method is known as quoting off "swap spreads". Simply stated, swap spreads are the cost of funds that bond investors incur to purchase securitized loans, or commercial mortgage backed securities (CMBS). Whether their cost of capital increases or decreases, they pass this difference along to the commercial mortgage lender. Typically commercial mortgage lenders quote an overall spread above Treasuries, and thus tend to pad their spreads for potential increases in swap spreads that are passed along to them from the bond investors. The traditional spread-above-treasuries method is good for the lender when "swaps" move down because their margins widened from when they first quoted the deal; however, if "swaps" move up, then commercial mortgage lenders face the scenario of being in a loss position, and run the risk of not being able to sell that particular loan or commercial mortgage backed securities. This is where the infamous "re-trade" usually comes into play, and the commercial mortgage lender has the option to stick to the original terms and incur a loss or renegotiate a higher quote with the borrower. Requesting a quote over swap spreads enables the commercial mortgage lender to fix a spread over the moving variable, thus eliminating a potential loss position. It's rare that the commercial mortgage lender will close a loan knowing they're "under water" on the loan, so approaching commercial mortgage lenders on the "swap" quote basis ultimately translates to tighter pricing on commercial mortgages are that much more likely to stick. Although this approach has been traditionally reserved for loans over $10mm, its an approach we suggest for all loan requests because helps trim some of the "fat" off the more conventional method of quoting an "all-in" spread over Treasuries.

In this ever-changing economy, Steelhead Capital is here to keep you current with any and all shifts occurring within the capital and commercial mortgage markets in order to help you make prudent investment decisions.

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With an extensive lender and commercial mortgages network, Steelhead Capital has built its reputation on structuring commercial mortgages and commercial real estate loans requiring both debt and equity placement. Fluctuations in the capital commercial mortgages present significant challenges for investors and we are pleased to provide financing, as well as, guide and advise its clients through the process of obtaining commercial mortgages. Whether you are looking for apartment financing, commercial financing, commercial mortgages, or creative "out of the box" real estate loan alternatives, we can help.

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