Tuesday, September 17, 2019

Should Commercial Mortgage Rates Be Higher?

By Jim Costello
November 5, 2018

Interest Rates
Real Capital Analytics

Jim Costello is Senior Vice President with Real Capital Analytics, New York. He has worked in the CRE space on issues of urban economics since 1990, including a 20-year stint at Torto Wheaton Research. 
He can be reached at

JimCostelloIt is tough out there for mortgage lenders. Given the run-up on the long end of the yield curve from midyear 2016 to 2018, one might have expected a similar increase in commercial mortgage rates. The intense competition from a variety of sources of debt capital, particularly upstart debt funds, has forced lenders to accept narrower margins.

Competition can be a good thing in a marketplace as it keeps participants on their toes and forces efficiencies. There comes a point, though, when no more efficiencies can be gained and then the knives come out. When no more efficiencies can be gained, market participants try to survive by accepting lower rates of return and lower margins which can be a bloody and nasty competition for market share.

The benefits that lenders get from commercial mortgages have been slipping as interest rates have been rising. The 10-year U.S. Treasury hit a floor of 1.5 percent in Q3'16. The average mortgage rate for a 7/10-year fixed mortgage stood at 4.6 percent at the time. Into Q3'18, the 10-year Treasury was up at 3.0 percent with commercial mortgages up to 4.9 percent.

I know what you are thinking, and you are right. The spread between the 10-year Treasury and average mortgage rates is not a direct measure of the margin that lenders earn. Certainly, though, it captures the difference between what these lenders might earn if they kept their capital in safe government instruments rather than commercial mortgages.

Since 2016 they have been willing to accept a narrower spread on the rates for commercial mortgages relative to what they might earn in the safe government assets. In the period from Q1'13 to Q3'16, there was an average 240 basis point spread between these series but since Q1'17 this spread has narrowed to just 205 basis points. Competition explains some of this willingness to accept a narrower spread.

Source: Real Capital Analytics, Federal Reserve Bank.

New lenders have entered the commercial mortgage market in this cycle and they are disrupting existing patterns of lending. At every industry conference, whether debt- or equity-focused, there have been scads of people promoting new debt funds throughout this economic expansion. The initial focus of some of these groups was to refinance the wave of maturities expected as a 10-year echo from the originations in the period from 2004 to 2006. Many of these debt funds, though, have found opportunities elsewhere.

Debt funds have been gaining the most market share for first mortgages on the riskiest of equity strategies. As a share of all lending activity these groups--identified in Real Capital Analytics's parlance as Financial Companies--have grown from 15 percent of all lending on value-add deals in 2015 to a 21 percent market share so far in 2018. Their lending activity has grown even faster for construction projects, from only a 7 percent share in 2015 up to 19 percent of the market so far in 2018.

These debt fund lenders have a high cost of capital relative to more traditional lenders. Lending on the riskier equity strategies is one way to counter this handicap. While we cannot quantify the share at this time, these lenders are also active in the mezz space.

                                Source: Real Capital Analytics.

For first mortgages on core/stabilized assets these debt fund lenders are less competitive than existing lenders with lower costs of capital. With loans tied to these strategies, debt funds have grown from a 9% share of the market in 2015 to an 11 percent share so far in 2018. These lenders are starting to gain market share even in this competitive space; here, though, competing no so much on pricing as by taking risks on loan standards.

One form of risk these debt fund lenders undertake is higher loan-to-value loans. For the 12 months through Q2'18, 20 percent of their loans originated at LTVs at 80 percent or greater. By contrast, this 80 percent-and-higher range represents only 11 percent of originations for all other lender groups. These debt funds lenders are gaining share in the market for commercial mortgages, in part, by taking on levels of risk that other lenders cannot because of regulatory constraints.

Source: Real Capital Analytics
Loan Database 
Office, Industrial, Retail and Hotel properties only Q2'17 to Q1'18.

This is not to say that debt fund lenders face no regulation. The standards of regulation applied to these lenders is different, however. Many of these lenders come to the market from the private equity fund world, with fundraising guided by various Securities Exchange Commission regulations and Department of Labor ERISA guidelines. More traditional lenders, though, will face loan-level scrutiny by their regulators looking to see that they are not taking on undue risks.

The risks that these debt fund lenders are willing to undertake are disruptive to the market. That word "disruptive" has taken on a particular meaning in this cycle. In many industries disruption is code for firms using innovative tools of modern technology to displace market incumbents. The disruption on the part of debt funds is not tech-driven so much as coming to the market with a different set of incentives. These lenders are not taking on risk for the sake of risk and market share; rather, they view lending risks from a different perspective. Again, many of these debt fund lenders come from the private equity space and have long experience managing complex commercial real estate projects. They are not making loans explicitly hoping for defaults as a way of gaining access to a property, but their underwriting is certainly colored by their experience in their equity investments.

The incumbent lenders in the marketplace simply have different return objectives on the loans they originate. The worst situation for these lenders is to originate a loan that ends in default which ends up in an REO situation. For a private equity fund operator launching a debt fund though, such a situation is not the end of the world. Again, the loans themselves need not be originated in the hopes of a default, but their underwriting can take such a situation into account. Viewing the loan as part of their basis on getting into a property generates a different view on lending risk.

Forecasts of interest rates have been notoriously wrong over the last decade. Every survey of professional economists since 2010 has shown an expectation that the long end of the yield curve would be higher about two years in the future. The surveys conducted in 2016 were actually right for once with the 10-year U.S. Treasury moving up from 1.5 percent to the 3.2 percent range now into 2018. Had mortgage lenders known that such an increase would be coming, they would have expected a sharper rise in mortgage rates than has been seen so far.

Competition is leading the providers of debt capital to absorb some of the impact of the rise in the long end of the yield curve--some but not all. Can lenders continue to absorb future increases? Competition from new sources of debt capital in the market adds a layer of complexity to this question.

Views expressed in this article do not necessarily reflect policy of the Mortgage Bankers Association, nor do they connote an MBA endorsement of a specific company, product or service. MBA Insights welcomes your submissions. Inquiries can be sent to Mike Sorohan, editor, at; or Michael Tucker, editorial manager, at

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