The margin is one line of the cost of a loan; the fees paid at the start and the end make the rate on the money actually used higher, and more so the sooner the loan is repaid.
Write down every cash flow between borrower and lender: the loan advanced net of the arrangement fee and the lender's costs the borrower pays, each interest and agency payment, and the repayment with any exit fee. The all-in cost is the IRR of that series. On an illustrative 60,000,000 five-year loan at 5.75 per cent, a 1 per cent arrangement fee, 250,000 of lender costs, an agency fee and a 0.5 per cent exit fee give an all-in cost of 6.23 per cent, 48 basis points above the coupon.
Worked in full in Real Estate Finance by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Term sheets lead with the margin, and borrowers compare offers on it. The margin is only one line of the cost. Fees paid up front reduce the money the borrower actually receives, and fees paid at the end add to what it repays, so the true rate on the money used is higher than the coupon. How much higher depends on how long the loan is outstanding, which is why two offers can swap places depending on the business plan.
| Term | Value |
|---|---|
| Loan amount | 60,000,000 |
| Swap rate (fixed for the term) / margin | 3.50% / 2.25% |
| Coupon | 5.75% |
| Term | 5 years |
| Arrangement fee | 1.00%, 600,000 |
| Lender's legal and valuation costs paid by the borrower | 250,000 |
| Agency and monitoring fee a year | 30,000 |
| Exit fee on repayment | 0.50%, 300,000 |
| Prepayment fee if repaid in years 1 or 2 | 1% |
Year 0 = loan − arrangement fee − lender costs
Years 1 to n = −(loan × coupon + agency fee)
Year n adds −loan × (1 + exit fee + any prepayment fee)
All-in cost = IRR of the series
In Excel, with the flows in B2:B7: =IRR(B2:B7). With quarterly payments, use the quarterly flows and annualise the result consistently with how the coupon is quoted, or use =XIRR on the payment dates.
| Year | Cash flow |
|---|---|
| 0: 60,000,000 less 850,000 of up-front costs | 59,150,000 |
| 1: interest 3,450,000 plus agency 30,000 | −3,480,000 |
| 2 | −3,480,000 |
| 3 | −3,480,000 |
| 4 | −3,480,000 |
| 5: interest, agency, principal and 300,000 exit fee | −63,780,000 |
| IRR: all-in cost | 6.23% |
The all-in cost is 6.23 per cent: 48 basis points over the 5.75 per cent coupon and 273 over the swap rate, against a quoted margin of 225. Spreading the fees in a straight line gives a close approximation: the 850,000 of up-front costs is 1.42 per cent of the loan, 28 basis points a year over five years; the agency fee is 5; the exit fee 10. That gives 6.18 per cent. The IRR is higher because a fee paid at the start has to be recovered with interest over the term, while the straight line simply divides it by the years; the exit fee, paid at the end, weighs slightly less than its straight-line share. Over a full term the difference is small; over a short hold it is not.
The all-in cost is the right figure to set against the property's yield and to use as the cost of debt in a levered return. The coupon is still the figure for the interest cover test in a loan sizing model, because the covenant is written on interest paid, not on fees.
A second lender offers a lower margin of 2.00 per cent, a 5.50 per cent coupon, with a 2.25 per cent arrangement fee (1,350,000) and no exit fee, the same lender costs and the same prepayment terms. Which is cheaper depends on when the loan is repaid.
| Repaid in year | Offer A: 2.25% margin | Offer B: 2.00% margin | Cheaper |
|---|---|---|---|
| 2 | 7.31% | 7.52% | A by 21 bp |
| 3 | 6.49% | 6.56% | A by 7 bp |
| 4 | 6.33% | 6.33% | level |
| 5 | 6.23% | 6.19% | B by 4 bp |
On the full term, the lower margin wins by 4 basis points. If the business plan is to refinance or sell in year 2 or 3, the higher-margin offer is cheaper, because its up-front fee is smaller and the extra 1.25 points of arrangement fee cannot be earned back in the margin saving over so short a period. Repaid in year 2, both loans also pay the 1 per cent prepayment fee, 600,000, which is why every figure in that row is so high.
The all-in cost of a commercial mortgage is the IRR of the borrower's cash flows: 6.23 per cent here on a 5.75 per cent coupon. Compute it at the expected repayment date, because fees paid up front cost more the sooner the loan is repaid. The free workbooks for Real Estate Finance carry the sizing and cover tests this cost feeds, and the mortgage constant adds amortisation to the same picture.
Approximately, divide it by the expected years outstanding: a 1 per cent fee over five years is about 20 basis points a year. Precisely, net the fee from the loan proceeds and solve for the IRR. On the illustrative loan, all up-front costs of 1.42 per cent add 28 basis points a year in a straight line, and the IRR gives a slightly higher all-in cost of 6.23 per cent against 6.18.
No, it depends on how long the loan is outstanding. In the illustrative comparison, a 2.00 per cent margin with a 2.25 per cent arrangement fee costs 6.19 per cent all-in over five years against 6.23 per cent for the 2.25 per cent margin offer, but 7.52 against 7.31 per cent if the loan is repaid in year 2.
On what the loan agreement defines, which is normally the interest and scheduled principal actually payable, not amortised fees. Use the all-in cost, 6.23 per cent in the illustrative case, to compare offers and to set the cost of debt against the property's return, and the coupon of 5.75 per cent for the covenant test.
This article is one calculation from Real Estate Finance. 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.
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