Discount Margin

Discount Margin (DM)

In the context of commercial mortgages and commercial real estate finance, the Discount Margin (DM) is a financial metric used to represent the average expected return of a floating-rate debt instrument (such as a commercial mortgage or a CMBS bond) over its benchmark index. It is essentially the effective spread that an investor earns over the reference rate—commonly SOFR (Secured Overnight Financing Rate) or LIBOR—taking into account the security's purchase price, its coupon rate, and its expected life.

Detailed Description

The Discount Margin is the most common way to express the yield of a floating-rate commercial mortgage when that loan or bond is being traded at a price other than par (100% of its face value). While the quoted spread is the fixed amount added to the index as defined in the loan documents, the Discount Margin reflects the actual yield to the investor based on what they paid for the debt.

If an investor purchases a commercial mortgage at a discount (less than par), the Discount Margin will be higher than the quoted spread. Conversely, if the mortgage is purchased at a premium (above par), the Discount Margin will be lower than the quoted spread. This is because the capital gain or loss realized at the loan's maturity is "spread out" over the remaining life of the loan and added to or subtracted from the periodic interest payments.

Key components and considerations of Discount Margin include:

• The Benchmark: Commercial mortgages typically use a floating index. The DM measures the return specifically in excess of this moving target.
• Purchase Price: This is the primary driver that causes the DM to deviate from the nominal spread. In distressed or high-interest-rate environments, many commercial loans trade at a discount, leading to higher DMs.
• Prepayment Assumptions: Because the DM accounts for the amortization of the discount or premium, the timing of the loan's payoff is critical. If a loan is paid off earlier than expected, a discount is "earned" faster, which increases the Discount Margin.
• Yield Comparison: Investors use the DM to compare the relative value of different commercial mortgage-backed securities (CMBS) or bridge loans that may have different coupons and price points.

In the Commercial Mortgage-Backed Securities (CMBS) market, the Discount Margin is the industry standard for pricing floating-rate tranches. It provides a "level playing field" for investors to understand the true risk-adjusted return of a loan, regardless of whether the underlying interest rate environment is rising or falling, by focusing strictly on the credit spread and price volatility.

Ultimately, the Discount Margin serves as a comprehensive measure of the total return an investor expects to receive for taking on the credit risk of a commercial property, adjusted for the price they paid to enter the position.