Figuring the Cost of a Loan

By Jeff Wilder

For H&MM

As the securitization of hotel loans grows ever more popular, it is of more than passing interest how loans originated via this process are priced to the borrower. In other words, what goes into how much interest you’ll be charged for a loan. I recently discussed this subject with financing executive David Kidd of Finova Realty Capital. His company is a major hotel loan originator. David provided valuable insight into the banker/underwriter’s thinking and I’d like to share it with you. His comments follow.

Loan Pricing: Spread and Rate

The prospect of locking in long-term, fixed rate, non-recourse financing at today’s low interest rates has created record volume in commercial real estate financing transactions around Wall Street. Usually, each transaction is unique, every asset presents individual strengths, and borrowers have very particular financing requirements. Understanding how modifications to the "conduit lender’s" basic loan structure affect deal pricing will help to save you time and money.

The margin, or "spread", applied to a pre-arranged index rate (e.g. a 10 year Treasury) will determine the interest rate for the loan’s term. The numerous factors that go into determining that spread vary from asset quality and organizational structure to environmental matters and pre-payment provisions. Establishing goals for the transaction, and creating a list of priorities early in the process, will help ensure a successful financing transaction.

Quality and Risk

Of foremost concern are the yield demands of investors in the commercial mortgage backed securities (CMBS) market. CMBS loans are priced based on the quality of the asset and risk associated with the individual loan. Asset quality is based on the hotel’s physical condition, the market it serves, and its position in that market relative to competition. Additional concerns include how the property is managed and accounted for. Keeping well-organized records, and having the back up documentation regarding special circumstances presented in the historical financial statements, also reflect on the quality of the asset.

The economic risk of any loan is fundamentally measured by the degree of leverage, as measured by both the loan-to-value (LTV) and the debt service coverage (DSC) provided by the assets’ net operating income. Simply put, the lowest spreads are made available to high quality assets in strong markets with low leverage requirements. As LTV and DSC constraints are "tested", a spread premium is ordinarily imposed to account for increased risk. The spread will increase depending on the leverage required (i.e. 60% vs. 75% LTV). Constraints vary, but in today’s market we find an 80% LTV to be the maximum leverage accepted. The same principle applies to to DSC; the higher the debt coverage provided by cash flow, the lower the spread.

Structure

Beyond quality and risk, loan structure plays a large part in determining loan pricing. Due to CMBS investor demands for steady, uninterrupted cash flows for defined periods, the market has established standard structures that lenders will provide to optimize both the rate spread to the borrower and the yield to the investor. For example, the best pricing is now achievable with a 10-year term and a 20 to 30 year amortization schedule. Alternative maturity schedules are available but, because they vary from the ideal with respect to the CMBS bond structure, these ordinarily command a spread premium. Typically, deviations from a basic 10 year term structure can add 10 to 30 basis points.

Similarly, customized pre-payment formulas that deviate from either yield maintenance or defeasance formulas impact the interest rate. Although the details of these methods are beyond the scope of this discussion, the important point to remember is that there are other options. However, expect that unique modifications will impact the spread level. For example, a declining prepayment penalty structure might add 30 to 50 basis points to the spread.

There are other concerns, beyond those already discussed, that also impact pricing. For example, is the hotel full-service or limited service, franchised or independent ?

The Ratings Agencies

The common denominator in the CMBS pricing equation is the ratings agencies. Ultimately, all lenders need to present the "pool" of loans being brought to market for ratings agency scrutiny. In order for the pool to bring the most value to the lender, it needs to be rated highly by agencies such as Moody’s or S&P. If there are issues of quality, risk or structure that vary from the ideal being sought by investors, it causes the overall pool’s bond rating to be less favorable and thus affects the marketability of the entire package.