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For better or for worse, interest rate hedging instruments have an important role to play when it comes to financing commercial real estate (CRE). For the past decade or so, these products have enjoyed a relatively low profile following the excesses of the period leading up to the global financial crisis (GFC). This is all set to change
One of the key features of European CRE lending is that there has always been a mismatch between lender and borrower requirements when it comes to income, given that the latter typically receives a fixed amount from their tenants, whist a lender requires a variable interest rate to match their back-to-back funding. To bridge this gap, typically a hedging instrument is used in the form of either an interest rate swap or an interest rate cap. Prior to the GFC the derivative of choice was the interest rate swap, but due to the ultra-low interest rate environment these have since been usurped by the interest rate cap.
Although interest rate swaps were the derivative of choice leading up to the GFC, it was this crisis that brought into sharp focus the perils of the instrument. Thanks to the demise of Lehman Brothers and the sobering message that hedge counterparties are not too big to fail, counterparty risk was promoted from a hypothetical risk to a genuine risk with profound negative consequences for impacted borrowers and lenders alike. In the case of the latter, not only were lenders also exposed (directly or indirectly) to counterparty risk, but in situations where loans turned sour they also found themselves in the unenviable position of being unable to instigate enforcement action in situations where this would mean terminating a swap and with it precipitating a significant close-out payment to the swap provider. This dire situation was exacerbated by highly leveraged loans and/or where long-dated swaps were involved which made it economically impossible to liquidate a loan given the eye-watering termination costs.
It is no surprise that in the wake of the GFC, market practice and regulation has sought to clean up these shortcomings in order to ensure that the risks of interest rate swap were carefully managed. Although these steps have been very much welcome, in many ways this has all been rather academic given that for the past decade or so, we have experienced record low interest rates and with it interest rate caps have dominated.
Just as interest rate swaps received their acid test in the wake of the GFC, now is the time for interest rate caps to be properly tested. The vast majority of CRE loans originated during the last decade have embedded the requirement of cap which must remain in place for the life of that loan. An increase in interest rates though will have a number of ramifications. First and foremost, counterparty risk becomes a real hot topic. Loan agreements typically provide that if certain ratings triggers are triggered then the cap needs to be novated to another cap provider and/or collateral posted. Given where interest rates are likely to go and the cost associated with these instruments it will be interesting to see how workable these replacement requirements are in practice. Similarly, when it’s comes to calculating financial covenants, the sincere hope is that interest covenants give credit to the strike rate under an interest rate cap. Failure to give credit to any interest rate cap could trigger a cash-sweep or worse, an event of default.
In circumstances where a loan is approaching maturity, the rise in rates is particularly acute. If a borrower is looking to exercise an extension option then that almost certainly will involve purchasing a new cap to cover the extension period and given where rates are at
, this is likely to be at an eye-watering prospect compared to what was paid on origination. In a similar vein, if a borrower is looking to refinance existing assets, then borrowing costs will have risen significantly compared to the previous financing. These exorbitant costs are likely to have a knock on effect, with a dampening of purchase prices that borrowers are prepared to pay to acquire assets and/or they may seek higher levels of leverage to fund these additional borrowing costs.
It is abundantly clear that the rising price of the interest rate cap will clearly have a serious impact on the CRE lending market, and although some borrowers may try to counteract this by trying to obtain a higher strike rate and/or a reduction of the notional, these approaches will not be hugely appetising for lenders given the heightened level of risk. Given the current interest rate environment, the appeal of the interest rate cap has somewhat diminished and with it the market is likely to witness the re-emergence of the interest rate swap as a more workable method of addressing interest rate risk. Ultimately, this is no bad thing given that interest rate swaps as a hedging product have been tried, tested and lessons learnt. Furthermore, compared to the period prior to the GFC, the levels of CRE leverage are at more workable levels and accordingly there is a greater capacity to absorb swap termination costs in situations where enforcement action is required.
The bottom line is that interest rate hedging is here to stay, and whether it takes the form of a cap or a swap will derive different benefits and headaches for borrowers and lenders alike. The key thing for the market to recognise is that regardless of which instrument is deployed, lessons are learnt from the past and that ultimately the chosen hedging product is structured in such a way that it proves to be friend and not foe to the lending structure. As a final thought, given the CRE lending market has proven itself to be a hotbed of innovation that has consistently learnt from the mistakes of the past and actively refined and finessed loan structures and documents to create a more robust loan product, I would not be surprised if the same applies to hedging, and who knows the binary choice of either a swap or a cap could be confined to the CRE lending doldrums. Either way this is definitely a hot topic to watch.