From modest projects to major development initiatives, interest rate derivatives (also known as interest rate swaps and caps) are becoming an increasingly common component of real estate financing transactions. A good deal of the credit for this trend can be attributed to the maturation and broadening of the derivatives market in general and a corresponding widening of understanding and acceptance of derivatives transactions.
The growth and influence of this market can be seen in the growth of London Inter-bank Offered Ratebased lending. The growth in LIBOR-based lending in the United States is partly attributable to the fact that the most liquid market for interest rate derivatives is based on LIBOR.
The most common uses of interest rate derivatives by real estate investors have been to hedge interest rate risk in connection with floating rate borrowings and to lock in a rate on a loan that is being entered into in the future.
For instance, an investor who borrowed $1 million at a floating rate based on LIBOR would be exposed in the event the rate rose. The investor could enter into an interest rate swap, that is, a bilateral agreement with a counterparty (most likely a derivatives dealer) that would have the effect of offsetting any changes in LIBOR. Under the swap, the payments would be made to the investor to the extent that LIBOR rose. Those payments would offset the additional interest that would be due under the loan as a result of the rise in rates. If interest rates fell the investor would make payments to the counterparty under the swap equal to the amount saved as a result of the reduction in the interest rate under the loan. By entering into an interest rate swap the investor would be giving up the potential windfall that it would realize in the event that rates fell, but would be protected in the event that rates rose.
Making Promises
Alternatively, the investor might choose to enter into an interest rate derivative referred to as an interest rate cap. In a cap transaction, the investor would pay a one-time fee in exchange for a promise by the other party to make payments to the investor to the extent that the interest rate in question rose above an agreed upon level. For instance, the cap might state that the counterparty will pay to the investor an interest rate equal to the extent to which LIBOR rises above 8 percent. The interest would be applied to an amount agreed by the parties at the outset of the transaction (in this case, $1 million, the amount of the loan being hedged). So, if LIBOR rose to 10 percent the counterparty would pay to the investor 2 percent on $1 million. The investor would use this money to offset the additional interest that it would be required to pay under the loan.
The benefit of the interest rate swap relative to the interest rate cap is that a typical swap does not involve an upfront payment, as does a cap. The advantage of the cap relative to the swap is that, other than the upfront payment, the investor would not be required to pay money to its counterparty in the transaction, even if interest rates fell. In fact, in the event that rates fell, if the investor held a cap rather than a swap, the investor would receive the benefit of the lower interest rate payments under the loan.
Various Combinations
Swaps and caps can be entered prior to the time a loan commences, at the same time or at a later date. One can also enter into a swap or cap that has a start date in the future, therefore locking in today's rates for a loan that commences some time in the future. Under certain market conditions the combination of a LIBOR-based loan and an interest rate swap or cap can produce a lower cost of funding than a simple fixedrate loan. Also, an interest rate derivative and a floating rate loan can be combined to result in a fixed rate of a longer duration than would be available under a simple fixed-rate loan. The flexibility offered by the many combinations of loans and interest rate derivatives transactions has appealed to investors.
While interest rate derivatives offer obvious benefits, they do so only when they are properly structured and the legal risks associated with them are properly addressed.
In order for an interest rate derivative to mitigate the risk encountered by a real estate investor, it must be structured with that specific risk in mind. Some things must be considered. What rate is the loan based on? Can a derivative transaction be structured based on the same rate? What size is the loan? The swap or cap must bear some relation to this size. Of what duration is the loan? What is the likelihood of prepayment? These issues and other should be addressed when considering a derivatives transaction.
There are a number of legal issues that must be addressed when considering entering into a derivatives transaction. For instance, under applicable regulations, there are limitations as to who can enter into such transactions. Also, as noted above, a derivative transaction is a contract. Like most contracts, a derivative transaction typically contains representations, events of defaults, corresponding consequences and other legal terms.
Finally, in contexts other than real estate financing it is common for parties in a derivatives transaction to post collateral to one another, in the form of cash or bonds, to secure performance under the contract. Under circumstances where a mortgage interest is being given in connection with the financing of real estate, as is most often the case, it is possible to structure the transaction so that this property also acts as security for performance under a related derivative transaction. This can become somewhat complicated if the counterparty to the derivative transaction is someone other than the lender or if they are one lender in a syndicate of lenders.
The use of interest rate derivatives in the context of real estate financing, once a novel technique, seems destined to become a staple among financing options offered to investors. The flexibility and protections afforded to investors by such transactions, provided the risks are addressed, is likely to drive the continued growth of this market.
Reprinted with permission from the May 27th, 2002 issue of Banker & Tradesman.