Musings on commercial
real estate finance
It should be re-emphasized that the actual percentage breakdown is constantly shifting and that the above allocations are simply approximates.
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Infographic: What goes into an agency rate?
August 20, 2019
You've likely seen news articles recently about the U.S. Fed reducing interest rates and how this will lower mortgage rates across the board. You may be asking yourself how this might impact you.
Perhaps you're the type that always has CNBC playing in the background or maybe you simply look at mortgage rates when you need to (or when those ads pop up "mortgage bankers hate this guy for revealing this secret!"). In either case, not many investors, whether in the commercial real estate industry or outside, know all the ingredients that get stacked into their multifamily mortgage.
So let's break them out. For reference, we will look at a typical 10 year loan from either of the agencies, Fannie Mae or Freddie Mac. FHA, CMBS and other debt sources stack up a bit differently. However, considering that nearly half of multifamily transactions happen through one of the agencies, it's a good place to start.
At the base of our (fixed) rate is the U.S. treasury (floating rates use LIBOR as the benchmark instead). Since our example references a 10-year loan, the 10-year Treasury Note is used as the benchmark.
This rate fluctuates daily and impacts the entire industry.
Agency Guarantee Fee
This is the fee that the agencies receive in return for guaranteeing the loan. The role of a debt guarantor is outside the scope of this article, however investopedia has a good summary of the history and economic importance of this role. The agencies are able to compete with one another by adjusting their guaranty fee. They might also introduce special programs where they reduce their fee in order to incentivize real estate investors to either provide affordable units or become more energy efficient.
Investor Credit Spread
After your loan is originated, typically the agencies will purchase the loan from the lender and securitize it for sale in the secondary market. While agency guaranteed mortgage backed securities are considered very safe investments, they do have more risk than, say, a U.S. treasury note. How much more risk depends on investor outlook of the U.S. commercial real estate industry and is reflected in this spread.
Again, investopedia has a nice article summarizing credit spread, with a video tutorial to go along with it.
The treasury + the investor spread is also known as the pass-through rate, as that is the rate that is “passed through” to the bond investor. Using the infographic above, the pass-through rate here is 1.60% + 0.56% = 2.16%.
After your loan is funded, a loan servicer is appointed to collect your mortgage payments. The servicer serves several key functions, including ensuring that your property operations are compliant with the loan requirements and reporting asset performance to the bond investors.
For this service, the loan servicer collects an ongoing fee that is built into your interest rate. With agency loans, the lender typically remains as the servicer. The lender is able to adjust how much of a servicing fee they would like to include (subject to agency-set minimums).
Yield Spread Premium
All of the previous sections sum up to what is called par pricing. In the infographic above, par is 3.7%. At par, the lender does not receive any premium on the sale of the note.
Interest rates above par pricing will net the lender a cash premium. How much of a premium the lender receives is subject to the secondary market, but the mechanics are explained well in this article (specifically, the section on yield-to-maturity).
To use an example, let's assume that bond investors are willing to pay 1% more for every 0.15% increase in interest rate. In the above infographic, there is 0.30% built into the rate, which means a bond investor would pay 2% more for this loan. If the loan amount was $10M, bond investors would buy the note for $10,200,000 which means the loan originator would gain $200,000 in premium.
This is how agency lenders compete with one another. Typically a lender will quote a combination of upfront origination fee (sometimes referred to as the financing/placement fee) combined with some amount of yield spread premium built in. This total profitability can be shared with the mortgage broker as well (both the fee and the premium).
It should be noted that the agencies require that lenders charge some sort of minimum fee (via upfront fee & yield spread) for their service so that no lender can totally bottom-out the market.
While yield spread can be used as a way for brokers to make additional commission without borrowers knowing (the amount of yield spread built in is rarely communicated), it can also be used as a good tool for real estate investors looking to minimize upfront fees. Lenders are often able to move many of the upfront financing fees into the yield spread, which means your out-of-pocket can be significantly reduced (in return for accepting a higher rate).
So why is the rate on my loan quote different?
When you receive loan quotes from different lenders, there are several factors that could make one quoted rate higher than the next:
1. Assumptions on agency exceptions/reductions. Lenders may assume upfront that they will achieve certain interest rate reductions from the agencies based on their evaluation of your property. All lenders can apply for these exceptions, but some lenders will prefer to quote conservatively (not assume waivers) and over-deliver if they achieve an interest rate reduction.
2. Servicing fee. Lenders have the ability to reduce the servicing fee, subject to a minimum amount set by the agencies.
3. Yield spread. This is the most likely reason for differences in rate. In combination with financing fees, this is how much the lender will make on the loan. Since the revenue from upfront fees and yield spread both go to the lender, borrowers can request whether they want to pay more upfront and less in rate or vice versa.
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