The blended note spread is a balance-weighted average, and it rises as the cheap senior class pays down, while the equity loses more to the fall in leverage than to the rise in spread.
A CRE CLO's weighted average cost of funds is each note's spread weighted by its balance: Σ(balance × spread) / total notes. On an illustrative $1,000M CRE CLO with $800M of floating-rate notes, it is 1,318.625 / 800.0 = SOFR + 1.648 per cent, or 1.982 per cent with issuance costs amortised over a three-year expected life. It does not stay there: once reinvestment ends and class A amortises, the same notes cost SOFR + 1.968 per cent.
Worked in full in CMBS and CRE CLOs by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A sponsor that finances its bridge loans through a CRE CLO compares the deal's cost with the alternatives: a warehouse line, a repurchase facility, a bank loan on the book. The comparison needs one number, the cost of the notes as a whole, measured the same way as the alternatives. It also needs a second number, the cost per dollar of collateral, because that is what is deducted from the loans' spread to leave the equity its excess spread.
| Class | Balance | Spread | Balance × spread |
|---|---|---|---|
| A | 580.0 | 1.40% | 812.000 |
| A-S | 90.0 | 1.80% | 162.000 |
| B | 47.5 | 2.15% | 102.125 |
| C | 42.5 | 2.60% | 110.500 |
| D | 40.0 | 3.30% | 132.000 |
| Notes | 800.0 | 1.648% | 1,318.625 |
Collateral is 1,000.0 of floating-rate bridge loans at SOFR + 3.25 per cent, SOFR is 4.00 per cent, issuance costs are 1.00 per cent of the notes and expenses 0.20 per cent of collateral a year. The retained equity is 200.0. All spreads are illustrative, chosen to show the mechanism, not quoted from any market.
1. Multiply each class's balance by its spread and add: 812.000 + 162.000 + 102.125 + 110.500 + 132.000 = 1,318.625.
2. Divide by the notes: 1,318.625 / 800.0 = 1.648% over SOFR, an all-in coupon of 5.65 per cent.
3. Add issuance costs spread over the expected life: 1.00% / 3.0 = 0.333%, giving 1.982% all-in, 8.0 of costs in dollars.
4. Cost per collateral dollar = advance rate × note spread = 80.0% × 1.648% = 1.319%.
5. Excess spread before expenses and losses = 3.25% − 1.319% = 1.931%.
In Excel: =SUMPRODUCT(Balances,Spreads)/SUM(Balances) for the note spread, and the same result times SUM(Balances)/Collateral for the cost per collateral dollar.
With the collateral paying 7.25 per cent, the notes 5.65 per cent and expenses taking 0.20 per cent of collateral, the equity receives 25.314 a year, 12.66 per cent on 200.0 before issuance costs and losses. The full equity calculation, with costs and loss rates, is worked in how to calculate the equity return on a CRE CLO.
During the reinvestment period, loan repayments buy new loans and the structure stays as issued. Afterwards, principal repays the notes sequentially, class A first. Nothing about any class's spread changes, but the mix does.
| A repaid | Collateral | Notes | Leverage | Note spread | Per collateral | Equity return |
|---|---|---|---|---|---|---|
| 0.0 | 1,000.0 | 800.0 | 80.0% | 1.648% | 1.319% | 12.66% |
| 150.0 | 850.0 | 650.0 | 76.5% | 1.706% | 1.304% | 11.42% |
| 300.0 | 700.0 | 500.0 | 71.4% | 1.797% | 1.284% | 10.18% |
| 450.0 | 550.0 | 350.0 | 63.6% | 1.968% | 1.252% | 8.94% |
Two things move in opposite directions. The note spread rises by 0.319 points, from 1.648 to 1.968 per cent, because class A at 1.40 per cent is a shrinking share of the notes. The cost per collateral dollar falls, from 1.319 to 1.252 per cent, because there are fewer notes against each dollar of loans. The equity return falls by 3.71 points, to 8.94 per cent, and most of that is the loss of leverage: the same 200.0 of equity now supports 550.0 of loans instead of 1,000.0. That is why sponsors watch the end of the non-call period closely, and why a deal that has delevered is often called and refinanced rather than left to amortise.
Delevering also lifts the coverage tests, since the senior notes shrink faster than the collateral. The arithmetic of those tests is in the CRE CLO overcollateralisation test.
Retained-equity return by advance rate, the break-even loss rate and the coverage tests are in the free CRE CLO workbook for this book.
Because principal repays the notes sequentially once reinvestment ends, so the cheapest class, A, shrinks first and the more expensive junior notes become a larger share of what remains. In the illustration, after 450.0 of class A repays, the weighted spread rises from 1.648 to 1.968 per cent although no note's spread has changed.
The note spread is measured on the notes; the cost per collateral dollar multiplies it by the advance rate. At an 80.0 per cent advance and a 1.648 per cent note spread, the collateral carries 1.319 per cent of funding cost against its 3.25 per cent spread, leaving 1.931 per cent of excess spread before expenses and losses.
Yes, mainly through lost leverage rather than the higher spread. In the illustration the equity return before costs and losses falls from 12.66 per cent to 8.94 as 450.0 of class A repays, a drop of 3.71 points, while the weighted note spread rises only 0.319 points. That fall is what makes an optional redemption attractive to the sponsor.
This article is one calculation from CMBS and CRE CLOs. 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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