Simple RE

Swaps - How They Affect Conduit Loan Pricing

If you've financed property with a conduit loan, you have heard the people at your originator of choice talk about swaps, swap spreads, and that they can impact the interest rate you will pay on your loan.  I wanted to know more about swaps and now that I have some answers, I thought I'd share with you.  The information here is pulled from two sources: an email interview I had yesterday with Damon Reed of Capmark Finance (Capmark bought GMAC Commercial Mortgage over a year ago), and from the Bridger Funding website.

Damon Reed explains the pricing process: "In the past, lenders would determine what breakeven pricing was and then add on [their] profitability to the spread along with any other add on’s (I/O, forward rate lock, etc.)  “break-even” would move as deals sold in the market and as swap rates moved up or down.  Generally, as swaps increase, your spread increases on a one for one basis.  Today, some lenders are quoting deals over swaps [rather than over treasuries] due to the volatile market."

Background on Swaps From the Bridger Funding Website: (See the source here)
Swaps -- also known as interest rate swaps -- are an important determinant in the pricing of most fixed-income instruments, including Commercial Mortgage Backed Securities (CMBS). Swaps are a security that most financial institutions utilize to manage interest rate risk. Interest rate risk reflects the potential impact that movements in general interest rates (e.g., U.S. Government Treasury Securities) will have on the value of fixed-income securities. For instance, as interest rates increase, the price (value) of fixed-rate bonds tends to decrease (at higher amounts for longer term bonds).

Swaps are agreements that reflect the notional exchange of fixed-rate interest payments for floating-rate interest payments. This allows an institution to hold a floating rate security, for instance, but effectively receive a fixed-rate of interest for the like term. Although there may be a cost to hold the hedge in place, the "insurance" premium is worth it to most institutions. While the physical exchange of interest payments doesn't necessarily take place, the market price of a swap contract fluctuates in such a manner as to emulate the exchange of payments. The market for swaps is very deep and liquid, and exists because different investors have different views of the direction of interest rates -- not to mention different exposures to rising or falling rates.

The swap yield, or rate, is the fixed-rate of interest paid (or received) in an interest rate swap contract. This yield is equal to the like-term U.S. Treasury Security yield plus a "risk premium", which is referred to as the "swap spread". Think of the swap spread as a generic risk premium that the market prices in to fixed-income securities to compensate for general interest rate risk. CMBS bonds, like most asset-backed bonds, are priced not just over like-term Treasury Securities, but swap spreads as well (in addition to asset-specific credit spreads to account for perceived risk of the subject asset class).

If swaps are an important determinant of CMBS value, why aren't they used more often as a benchmark in quoting CMBS conduit loans?
While larger CMBS conduit loans are often priced over swaps, the traditional practice of the industry has been to index their loan spreads only over the like-term U.S. Treasury Yield (with an increasing caveat explained in the loan application that allows for adjustments to the interest rate based upon swap spreads). The Treasury yield remains the most popular loan pricing index because it is a very relevant determinant of CMBS bond yields, and tend to be more volatile than swap spreads or CMBS-specific credit spreads. In addition, Treasury yields are better understood by many property investors, who find that it’s easier to locate the current Treasury yield in newspapers and web sites (although a few sites, like BridgerFunding.com, also display swap spreads.)  Find swap spreads here.

How can swap spreads affect your mortgage interest rate?
Sustained increases in swap spreads usually result in lenders’ raising their loan spreads (and/or inserting language in the loan application that adjusts the interest rate for future changes in swap spreads). In addition, if your loan’s interest rate has not been locked, an increase in swap spreads could have a material impact on the value of your loan. Accordingly, in rare circumstances the lender may work with you to adjust the interest rate when it is locked to offset some of the decline in value. The impact of changing swap spreads affects all mortgage players equally.

What factors tend to cause swap spreads to increase?
Typically, interest rate swap spreads will rise with Treasury yields. This is especially the case when the market starts to perceive that higher Treasury yields may last for a while. As interest rates start to rise, the value of fixed-rate bonds decreases, which tends to increase interest rate swap spreads. In other words, the generic risk premium expands in the face of expectations for rising rates. In addition, swap spread movements can be exacerbated by the aggregate impact of asset-backed security hedging, which often becomes acute with quick jumps in interest rates.

As Mr. Reed said when he referred me to the Bridger information, "This will give you some color on swaps, but again it doesn’t help you in today’s market because we are just guessing where break-even is today.  Until all the stacks of a CMBS sells in the market, spreads will continue to be a guessing game.  I expect this to flush out next month as most of the supply will be gone."

In the interest of full disclosure - I've done many deals with Damon, and a few with other originators. I have a sense of what kind of service is standard in the market.  Damon and his team go well beyond "standard"; they have executed far better than any lender I've worked with.  That's why I went to him to help me with this post. That's why I'm plugging him and his team. And that's why we keep doing deals with him even though we are in California and he is in Birmingham, Alabama. If you are looking to do a CMBS/Conduit loan I suggest you give them a shot at your business.

6 Nuggets from the Self Storage Association Conference

A few things I learned at the Self Storage Association conference recently held in Las Vegas:

Operations

1. Ask customers when they are at the counter how many stores they called or visited before they came to rent with you.  According to Ken Nitzberg from Devon Self Storage, 53% of his customers don't shop around.  It's a strong signal that the customer is not price sensitive.This allows you to "spot price", i.e. offer a higher price and/or give fewer concessions than you normally would.


2. Dan Hobin at G5 Search Marketing has a very innovative approach to lowering your customer acquisition cost. He has put together a solution that not only gets you marketing online in a meaningful way with little hassle, but has a great way to track the effectiveness of your spending.  I haven't tried it out yet, but he got lots of raves at the conference from some of the larger operators.  We plan on giving his service a try with a number of our portfolio properties.


3. Devon Storage Group is able to get an 89% penetration rate selling insurance to cover their tenant's stored goods. If I understood Ken's comments correctly, they achieve the high penetration because they require every tenant to purchase insurance or show proof that they have their own coverage.  Sounds like it might be a bit difficult to execute if you are in a soft market. However, it's probably worth trying; by my estimate that is $400 - $800 to the bottom line each month because there is really no incremental cost to the add-on sale.


4. Jefferson Shreve, president of Storage Express made me wonder why we don't at least attempt to rent the space over the phone. I mean actually close the deal.  Most operators talk about trying to convert phone inquiries to store visits and store visits to signed rental agreements. Storage Express operates nearly 70 locations with no on-site staff.  They close every deal over the phone or online. 

Finance

1. Conduit Lenders are starving (no surprise). However the conduits that are quoting deals are offering spreads of about 200 basis points over the ten-year treasury yield.  That is a big spread, but the all-in rate is still less than 6.5%.  Not as good as we were seeing 6 months ago, but still very low relative to historic rates. 


2. LIBOR typically trades within a quarter point of the Fed Funds Rate.  The primary reason it is much more volatile is because there is no Federal Reserve intervening in Great Britain.

Meetings

I know that this isn't really on-target with the commercial real estate focus of this blog, but its on my mind so I thought I would share.

Here are seven good reasons to have them:

1. To build personal relationships
2. To give public recognition
3. To make a presentation that requires visuals or group interaction (preferably both)
4. To inspire the group in a way that a memo or email never will
5. To collaborate, discuss, debate, and decide
6. To brainstorm
7. To give candid, personal feedback on someone's performance

Here's some ways to make meetings a frustration

1. No one takes charge and keeps things on track
2. Meet only to give and receive reports that could just as effectively been communicated in an email or memo.
3. Discuss, at length, items that pertain to only a portion of the assembled group (the group within the group need their own meeting)
4. Start late and go over the allotted time
5. Stifle discussion or conflict - if you are having a "discussion" but most are not talking and the others are only agreeing, there is a problem.

Training Self Storage Employees

Three factors have pushed us to train our employees more effectively. 

1. The self storage business is becoming increasingly more competitive.


2. We are buying properties with a value-add strategy and that means we need excellent execution at the operational level.


3. Our portfolio is spread out geographically which means we need managers who can be effective without a lot of continual hand holding because it is difficult to visit all of our locations as often as we would if they were all concentrated in one metro area.

Although we don't have it down yet, here are some of the things we are learning as we have been training our employees to be more effective converting phone inquiries to store visits and rentals.

1. Training in a teleconference environment is difficult, but it is better than nothing. You have no idea who is engaged and who is falling asleep.


2. It is more effective to follow up any teleconference training with some written materials that outline everything covered while on the phone.  It is likely that the people working behind the counter at a storage facility were not good students when they were school age.  They are probably not taking notes, and if they are they may have messed them up.


3. Record the teleconference/webinar and let the participants watch or listen to it again.  If you are interesting and dynamic enough in your training that they listen to you again you should take it as a compliment.


4. Follow up relentlessly with activities that reinforce the learning and force the participants to apply their newly acquired knowledge. 
   
   We have our on-site managers review and critique their own "secret shopper" calls. In addition, they listen to the calls of their colleagues and vote for the best one. We are starting to record live calls so that our employees can listen to themselves interact with real live prospects, not mystery shoppers.


5. Make the follow-up learning/application activities as fun as possible. 
   
   If you can't make it fun, at least make it so obviously relevant to their job performance that the participants want to engage in the activities.  So far we've made it a contest with a prize awarded by the voting of their peers and a second "editors choice" award decided by me so that I can point out calls that have an excellent section that can be used to illustrate one of the sales strategies covered in the training.  We need to get more creative in this regard.


6. Once you train your staff and begin monitoring how well they perform the new behaviors, you will quickly realize that some are catching on much much more quickly than others, others improve slowly, and a small group makes almost no improvement at all. 


7. The ones catching on the fastest need more attention and coaching, not less.  Eventually they can help the middling group.


8. The ones who are making no progress probably have an attitude problem.  If you care about the behavior enough that you are taking the time to train and monitor, then you should consider replacing these people or changing their role.


9. Your  employees with positive attitudes will be grateful that you are helping them do their job better and you will improve their commitment and loyalty to your company.


10. Training allows you to hold your employees to a higher level of accountability because you are taking away excuses for poor performance.


11. Training is also a tool to help build camaraderie among employees who rarely interact, because through the training they have some shared history. 


12. It's not all about the phone, they need training on how to handle email inquiries as well.


13. I wish we started sooner.

What's Coming Up

Sorry for going radio-silent on everyone.  I was on vacation for a week and then I spent 3 days in Las Vegas visiting portfolio properties, having a marketing pow-wow with my property management staff, and attending the Self Storage Association conference and trade show.

Here's what's on the docket for the next few posts:

1. What I learned at the conference in Vegas
2. Talking a little about Swaps.  What they are and how they affect spreads on CMBS loans.
3. Talking about what I've learned trying to train employees
4. Of course I'll talk about the loan assumption I've been posting about recently

My two oldest daughters play soccer, and I'm the coach.  I ran my rear end off this evening, so I'm pooped.  I'll start with these topics in the next day or two.  Goodnight.