Can someone help me understand the mechanics of how spreads are calculated and how a lender actually makes money?
For instance, let’s say a LifeCo prices a deal at 150 bps over the 10 Year UST. What does that 150 bps go towards? Is it purely profit? Does it cover overhead and then some of it is profit?
And why do they choose to price off the UST vs another index?
Thats the risk free rate - they're making T +150 as interest im not sure what you're asking
You are over complicating interest rates.
Interest rates end up being quoted as a spread over a "risk free" index, but that just means if a lending institution can earn 4% on their money (10-yrs fixed) backed by the full faith & credit of the US Federal Govt, they want to earn 150 bps on top of that 4% to lend money money backed by a Class A multifamily asset.
What you are [indirectly] getting to is that lenders often have their own cost of capital, but that is going to vary lender by lender. In the case of life insurance companies, they take in premiums from their customers and will have a historic payout rate on that pool of capital. They need to lend out that money at a rate that is > their average payout, net of overhead, to make a profit.
Lenders make their money the same way an equity shop would. They “invest” in the deal at the bottom level the capital stack with a fixed return. (Keeping this high level).
I don’t work at a lifeco but my cost of capital is close to SOFR +50. In a perfect world, if I was charging a client S+150, I’d make 100 bps. There are also other fees involved such as origination fees that will juice the lender’s return.
In regards to expenses, I think that normally goes to an entity level thing opposed to a single loan appearance.
Depends,they want a certain return over the RFR. there's origination fee's thought hat's usually paid in cash at the table or premium on the bond. For LifeCo many of those shops will charge a UW fee and expenses but yes have some fees associated and baked in to cover the cost of work on the loan making it worth their while. Many LifeCo's aren't as big as the top 10 shops and will source out the AM and compliance of the loan to a Servicing shop or lender that does multiple other types of assets and therefor they have to pay a Servicing fee or AM fee to another shop so that will be baked in.
Thanks everyone for the help! Sorry for a basic question but how do LifeCos determine cost of capital and what index they use to price over?
For a LifeCo, is it just the premiums they pay out?
Each life co is different with different risk appetites but predominantly they will set their spread based on where corporates trade relative to the corresponding treasury, usually double and triple b’s are the most comparable to real estate. For instance, corporate spreads gapped up this week and so we’ve had numerous life cos come back to us and widen their quotes by a similar margin (15-20 bps minimum).
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