Two loans, the same size. Gross margin overstates the wide loan's advantage by a factor of seventeen — and the whole of it rests on a default estimate.
Two loans of the same size to the same sponsor. One is a 200-basis-point senior loan against a stabilised asset; the other a 550-basis-point whole loan against a transitional one. The margin says the second is better by 2.75 times. The return on capital says it is better by 1.10 — a tenth. The margin overstates the advantage by a factor of about 17.
Worked in full in The Real Estate Debt Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
That is what “a lending business that manages to gross margin will select the wrong deals” means when it is written out. On this pair the margin happens to point at the same answer, for reasons that are almost entirely wrong — which means on a slightly different pair it would point at the wrong one.
Fees first, because they annualise over the term and a short loan spreads them over fewer years. Then the three deductions: what the lender pays for its own money, the expected loss, and the cost of doing the work.
| Loan A | Loan B | What it is | |
|---|---|---|---|
| Margin over the reference rate | 200 | 550 | what the term sheet says |
| Arrangement fee, annualised | 15.0 | 50.0 | bigger effect on a short loan |
| Exit fee, annualised | — | 33.3 | |
| Gross revenue | 215.0 | 633.3 | |
| less cost of funds | −60 | −60 | the lender’s own funding |
| less expected loss | −7.5 | −90.0 | PD × LGD |
| less operating cost | −15 | −45 | underwriting, servicing, monitoring |
| Net spread | 132.5 | 438.3 |
Look at the fee line. Loan B’s 1.50% arrangement fee over three years is worth 50 basis points a year against Loan A’s 15 over five — and the exit fee adds another 33.3. Fees close some of the gap in B’s favour. The expected loss and the operating cost open it back up. Neither appears in the number anyone quotes.
Net spread is still not the return, because the two loans do not tie up the same capital. A transitional whole loan is risk-weighted three times a stabilised senior loan, and the capital is the scarce thing.
| Loan A | Loan B | |
|---|---|---|
| Profit a year | 662,500 | 2,191,667 |
| Capital held | 2,000,000 | 6,000,000 |
| Return on capital | 33.1% | 36.5% |
| Margin says B is better by | 2.75× | |
| Return on capital says B is better by | 1.10× |
306 bp of net spread advantage — 306 basis points — and only 3.4 points of return on capital, because it took three times the capital to earn it. That is the whole discipline in one comparison, and it takes eight rows.
B’s remaining advantage rests on an estimate. Move the probability of default and hold everything else constant.
| Loan B’s probability of default | Expected loss, bp | Net spread, bp | Return on capital | Verdict |
|---|---|---|---|---|
| 1% | 30.0 | 498.3 | 41.5% | B still wins |
| 2% | 60.0 | 468.3 | 39.0% | B still wins |
| 3% | 90.0 | 438.3 | 36.5% | B still wins |
| 4% | 120.0 | 408.3 | 34.0% | B still wins |
| 5% | 150.0 | 378.3 | 31.5% | B now loses to the senior loan |
| 6% | 180.0 | 348.3 | 29.0% | B now loses to the senior loan |
B ties with the senior loan at a 4.36% probability of default — 1.45 times the assumed 3%, or 136 basis points of PD. That is well inside the error of any default estimate. A 350-basis-point margin advantage that disappears if the estimate is wrong by less than half is not a margin advantage. It is a position on the accuracy of a PD estimate, taken without anyone saying so out loud, and it belongs in the credit paper in exactly those words.
Rate floors have a habit of being given away late in a negotiation, because they cost the borrower nothing on the day the loan is signed. Here is what one is worth on the senior loan.
| If the reference rate falls by | The floor earns, a year | As extra margin | As a share of Loan A’s credit margin |
|---|---|---|---|
| 25 bp | 125,000 | 25 bp | 12% |
| 50 bp | 250,000 | 50 bp | 25% |
| 100 bp | 500,000 | 100 bp | 50% |
| 150 bp | 750,000 | 150 bp | 75% |
| 200 bp | 1,000,000 | 200 bp | 100% |
| 300 bp | 1,500,000 | 300 bp | 150% |
A 150-basis-point fall in the reference rate over a five-year term is unremarkable, and on this loan it is worth 750,000 a year — 75% of the entire credit margin, the margin that took weeks of underwriting to justify. The negotiator who concedes the floor to close the deal has given away more than the credit team gained by pricing the risk correctly. It is worth computing this line before the final session rather than after it.
A loan that repays after eighteen months of a five-year term has not earned what the committee approved — that is the received wisdom, and the loan itself flatly contradicts it.
| Loan A held for | Revenue, bp | Operating cost, bp | Return on capital |
|---|---|---|---|
| 5.0 years | 215.0 | 11.0 | 34.1% |
| 3.0 years | 225.0 | 15.0 | 35.6% |
| 1.5 years | 250.0 | 25.0 | 39.4% |
| 1.0 years | 275.0 | 35.0 | 43.1% |
Held to term the senior loan returns 34.1% on capital. Repaid at eighteen months it returns 39.4%, because the arrangement fee annualises over a shorter life and the fee is larger than the extra underwriting cost per year. On the loan considered alone, an early repayment makes the lender more money.
The capital was committed for five years. If the loan goes away at eighteen months the money has to be re-lent for the remaining three and a half, and that is where the sentence is really about.
| Replacement margin | Total profit over the five years | Against holding to term | Verdict |
|---|---|---|---|
| 2.00% | 3,637,500 | +225,000 | still ahead |
| 1.75% | 3,200,000 | −212,500 | the early repayment has cost money |
| 1.50% | 2,762,500 | −650,000 | the early repayment has cost money |
| 1.25% | 2,325,000 | −1,087,500 | the early repayment has cost money |
| 1.00% | 1,887,500 | −1,525,000 | the early repayment has cost money |
With no prepayment protection the lender can absorb about 13 basis points of margin compression before the early repayment leaves it worse off over the five years it had committed. That is a very thin tolerance, and it is why the instinct is right even though the loan itself did better.
Which reframes what prepayment protection is for. It is not a penalty and it is not a windfall. It is the amount of margin compression the lender can survive if the loan goes away early. On this loan, 100 basis points of protection widens the tolerance from 13 basis points to 41. That is a far better argument to make across a table than “we always ask for it”.
State the return on capital next to the margin, not instead of it — the two together are the comparison, and either alone is a half-truth. State the probability of default at which the deal ties the alternative, because that is the estimate the approval actually rests on. And state the margin compression the deal can absorb on an early repayment, because that is what the prepayment clause is buying.
None of the three takes more than a spreadsheet column. All three change which loans a committee approves.
This article is one calculation from The Real Estate Debt Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: real estate investing, finance and fund management → · All 1706 articles →
If this book helped — or didn’t — a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.