Recent tightening monetary policy has brought to the forefront lenders utility of rate swaps and caps for CRE loans. With the stable interest rates of the past decade or so, these were largely kept in the closet. CRE investors have long had multiple avenues for hedging against rising interest rates. With the FED’s commitment to raising interest rates, however, renewed by higher-than-anticipated inflation, CRE lenders have brought these tools out as standard fare.
For investors with floating rate debt, there are two prominent tools (options) to hedge against rate climbs: an interest rate swap and a cap. A swap offers an investor an opportunity to exchange a floating interest payment for a fixed-rate payment for a certain period of time. A cap, on the other hand, fixes an upper limit on the rate a borrower will pay at the cost of an upfront payment. In the event that interest rates advance higher than the market anticipated, these types of positions can help investors avoid additional capital costs. However, if rates do not rise as much as expected, the borrower may have spent capital unnecessarily or incurred additional cost.
A few terms will be helpful going forward:
Interest Rate Swap: This gives the borrower the ability for a borrower to exchange a loan with a floating interest rate for a fixed rate profile for a certain length of time. The fixed rate is based on the current forward curve for the benchmark interest rate. A common benchmark rate used today is SOFR.
SOFR: The Secured Overnight Financing Rate is a broad measure of the cost of borrowing cash overnight, collateralized by Treasury securities. The SOFR is calculated as a volume-weighted median of transaction level data from the Bank of New York Mellon and the U.S. Department of the Treasury’s Office of Financial Research. A SOFR value is published each business day and is now being used as a replacement benchmark for the LIBOR rate being phased out.
Forward curve: A forward curve is the present-day expectation of how a measure will perform in the future. As such, forward curves are dynamic and can shift greatly as perceptions of the future change. Forward curves for benchmark interest rates, such as SOFR, are used for a variety of purposes, including in determining the contractual rate in an interest rate swap and a factor in the price of interest rate caps. Consider this a pricing guideline for the market.
Two-way Breakage: Transfer of funds when the swap position is terminated. If the contractual rate is less than the market replacement rate, then the borrower receives a payment. The borrower is obligated to pay, however, if the market rate is above the contractual rate.
So, swaps and caps are hedging tools that allow investors to mitigate interest rate increases after the loan is taken. Using them, however, increases the borrowers cost in the loan. And with swaps, there may be an additional cost at the time of breakage.
Is there a way to offset or avoid these costs? One obvious way is to not use either of hedging tools and accept the risk of increasing interest rates with a variable rate loan. This is typically what keeps CRE investors sidelined in rising interest rate environments. Unfortunately, many investment opportunities are missed by sidelining investment since the dynamics that make loans a higher risk often make CRE values decrease, resulting in higher cap rates and lower investment risk. Higher cost of debt can be offset away from the loan by negotiating a lower price or better terms for the asset being acquired.
The fundamentals of the CRE capital market are good. There’s an estimated $1 trillion of capital available and looking to be placed. The volatility of interest rates and the uncertain economy have shrunk the buyer/borrower pool, so less competition (demand) for loans. Supply:demand. If you would like to explore these tools and opportunities further for your next acquisition, give us a call.
We offer a variety of products and services, ask us how we can assist you today. We work for you, not the lender.
Today’s post is written by Michael Green, Commercial Loan Originator for Counsel Mortgage Group, LLC.
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