Commercial lenders should be aware of the important factors that drive customer behavior to borrow funds. Our clients borrow from us when they refinance debt, or purchase equipment, real estate, or finance working capital. However, there are three key elements that make debt especially appealing for borrowers. Commercial lenders that understand these three elements can better position themselves for success.
The Three Key Elements to Borrower
There are three market elements that can make borrowing more appealing. These three elements are the index rate (10-year Treasury yield), loan credit spread and the availability of credit. In today’s market, all three elements are particularly attractive for borrowers – not necessarily appealing to lenders.
The price of credit in the market is the sum of (a) the lender’s cost of capital and funding, and (b) the perceived credit risk to the lender. The lender’s cost of capital and funding is best measured by the 10-year Treasury yield. The 10-year Treasury is an indicator of the market’s confidence and is tightly correlated to the long-term growth of the economy. The yield on 10-year Treasury is shown in the graph below from 1962 to the present. The current yield is just above 2.4% and is 3.7% below the historical average over these 60 years. The current yield of 2.4% is also only 96 basis points above the all-time low of 1.47% seen in June 2016.
The index is extremely low and represents a cheap opportunity for borrowers to take debt. However, our bank customers do not get to borrow at the index rate — banks price loans based on demand and supply of credit, and the inherent riskiness of the credit.
The second key element of borrower demand for credit is the loan credit spread. Trepp CMBS Research tracks real estate loan spread from 2010 to the present (the graph is shown below). These spreads are tracked nationwide at the date of loan issuance. The current national average spread of 2.27% is 11 basis points within the lowest observed over the tracked period.
Not only is the index low by absolute and relative measures, but loan spreads are at modern-day lows. This makes it very attractive for customers to take on more debt.
The third element that makes debt attractive is the availability of credit. If market conditions allow more customers to qualify for more credit, the debt market becomes more attractive for borrowers. There are many ways to measure the supply of credit. However, one of the simplest and most compelling is to track average debt yields for newly issued loans.
Debt yield is calculated by taking the underlying property’s net operating income (NOI) and dividing it by the loan’s balance. The debt yield represents a lender’s return in the event of foreclosure at the inception of the loan. As we discussed in multiple articles, debt yield is a less biased indicator of credit quality than debt service coverage ratio (DSCR) or a loan-to-value ratio (LTV). A lower debt yield signals more lending confidence or greater competition for credit. Historically, lenders set debt yield to 10% to 12% minimum. A typical 10% debt yield loan currently would demonstrate 1.4X DSCR and 62% LTV. A typical 1.2X DSCR and 75% LTV loan will result in an 8.4% debt yield.
Trepp research shows that debt yield on newly issued loans is decreasing nationally and is the lowest level since 2010. In some regions, such as Pacific and Central, debt yields are falling at a rapid rate. While debt yields nationally are still above 10%, in some regions and some cities, average loan debt yields are below 10%. The national average has fallen from approximately 12.7% to 10.4% over the last nine years.
Dropping debt yield in the industry is a reflection of competition and loosening of credit standards at banks, credit unions, and other lending institutions. That is good news for borrowers, but a concern for conservative lenders.
We tell our borrowers that we have a sale on loans. First, as a bank, our cost of securing capital and funding has rarely been this low for the last 60 years. Second, credit spreads are also near historic lows and are lower than at any time since the last recession. Third, banks are very motivated to lend, and after 10 years of economic recovery, most of us have forgotten the cost of a downturn. This all bodes well for borrowers in the market for debt. Lenders must understand the confluence of factors motivating borrowers to take debt, but also exercise safe lending practices.
Submitted by Chris Nichols on May 15, 2019