The Federal Reserve is expected to continue raising interest rates this year. This means that borrowers with floating-rate debt must mitigate economic risk. The current situation increases the potential of rates and debt-service payments going higher, thereby landing the borrower in a negatively leveraged position.
In other words, borrowers need a hedge to protect themselves. In commercial real estate finance, interest rate caps and swaps are tools to mitigate the borrower’s risk. Mortgage brokers should be aware of the market factors that signal the need for hedging and understand why it’s a crucial strategy to manage exposure. They must be able to explain to their clients how methods such as caps and swaps work and offer tips for assembling a hedging plan.
“Conventional and natural hedging techniques include diversification of asset types, favoring equity over debt, timing the market for more favorable circumstances and betting on rent growth during times of inflation.”
Interest rates have increased as the Fed has tightened monetary policy over the past year. It was the most aggressive period of monetary tightening in more than 40 years, with a total of seven rate hikes, including four consecutive 75 basis-point increases. At the end of 2022, the federal funds rate stood at a target range of 4.25% to 4.5%. In February 2023, the Fed added an increase of 25 basis points, and the tightening is expected to continue but at a more gradual pace.
As rates have increased, so have lending costs and capitalization (cap) rates, which translate to higher risk. When financing costs and perceived risk increase, investors demand higher rates of return to offset the exposure. Consequently, as cap rates rise, valuations fall. And when the cost of borrowing exceeds the rate of return, negative leverage occurs.
According to research from Moody’s Analytics, 30% of commercial mortgage-backed securities loans exhibited negative leverage in third-quarter 2022 due to the rapidly rising costs of financing and relatively low cap (return) rates. Some borrowers are entering deals aware of negative leverage and hedging their bets on rent increases (a natural hedge). Their hope is that rising rents will gradually increase the net operating income (NOI) and rate of return to outpace the growth of debt service on floating-rate instruments.
With the current economic conditions, however, the degree of certainty that anyone can anticipate the market’s movements over the next several years is very low. Therefore, borrowers need additional interest rate hedging strategies to ensure long-term positive leverage, NOI growth and solvency.
Commercial real estate finance is inherently risky, yet experienced lenders, brokers and borrowers can prevail under most economic conditions with the appropriate tools. Hedging is a prudent strategy for many investments and is often lender required. When a broker’s clients are buying real property, hedges reduce the risk to individual assets and portfolios, as well as business and personal credit, by preparing for worst-case scenarios. Hedges essentially act as economic insurance.
It’s best to develop a hedging strategy early in the process of negotiating a deal because it is hard to switch course later. There are many variables and considerations in choosing a hedging strategy, so it’s best for investors to consult a qualified and experienced commercial mortgage originator and hedging advisor while in the planning stages.
Here are some reasons that borrowers and originators should consult a hedging advisor:
• Hedging approaches and products can be very complex.
• They’ll need help understanding the various documents and processes that are involved.
• Soliciting contract bids from multiple counterparties will result in the best execution.
Only the borrower, with the aid of their mortgage originator or hedging advisor, can make the call as to which hedging strategy is correct. Some combination of natural hedges and derivatives will work for most investors and their deals. Several variations of each derivative type are available, and one may best suit the borrower’s unique transaction and objectives.
Conventional and natural hedging techniques include diversification of asset types, favoring equity over debt, timing the market for more favorable circumstances and betting on rent growth during times of inflation. With increasing costs of funds, raising as much equity as possible is sensible and sometimes necessary. Loan-to-value limits have tightened as lenders have become more conservative.
Borrowers also can delay development, acquisition or refinance plans until conditions are more favorable. These plans may not always be practical, however, if high expectations of growth and returns by investors demand action before economic factors are ideal. Moreover, the Fed isn’t likely to change direction anytime soon, so the grass may not be greener for years.
In the multifamily housing market, for example, rent growth has been a reliable hedge for commercial real estate owners as demand for units has caused valuations to soar. But with inflation restricting consumer and business budgets, and development activity catching up, rent growth has started to slow.
According to Realtor.com, U.S. apartment rents were up 3.4% year over year this past November, the smallest increase in 19 months and the 10th month in a row that annualized rent increases had slowed. Consequently, rising rents aren’t something that owners can count on to prevent negative leverage.
Use of caps
Each of the following approaches are valid, but the practicality and degree of protection offered by them may not be enough to make a deal feasible in an environment of rising rates and diminished returns. Property derivatives (which allow investors exposure to real estate by replacing the properties with the performance of a real estate return index) are an alternative solution to bridge the gap, preventing financial stress and default risk when rates rise. Caps and swaps also are used by creating a hedge through a derivative contract.
An interest rate cap is, fundamentally speaking, an insurance policy against rising interest rates. It is a limit on how high the interest rate can rise on variable-rate debt. It is tied to a short-term index such as the Secured Overnight Financing Rate (SOFR).
The interest rates on a large portion of commercial real estate loans are variable, so that when rates increase, so do debt-service payments and total financing costs (potentially pushing the asset or portfolio into negative-leverage territory). Rate caps create a ceiling that the interest rate cannot exceed. Once the interest rate exceeds this cap, the counterparty (a lender or a third-party hedge provider) will reimburse the borrower the difference between the current index or reference rate and the cap. The borrower still makes the principal and interest payments as stipulated by the original note on the asset.
To mitigate the risk of the rate rising above the cap, the counterparty requires a premium or upfront fee. In a rising rate environment, the cost of a rate cap can be high, but it is often well worth it to protect the solvency of the project. In summary, the primary advantage of an interest rate cap is that borrowers are shielded against substantial interest rate increases and can even benefit when rates fall. Conversely, the key disadvantage is that obtaining a cap agreement requires an upfront cost that can impinge liquidity at the outset of a deal.
Use of swaps
Another derivative instrument is a swap, which involves a derivative contract between the borrower and a counterparty to substitute a floating rate for a fixed reference rate during the term of the agreement. The swap rate is a fixed interest rate to be paid by the borrower.
In this arrangement, the counterparty will pay the floating rate to the borrower and the borrower will pass this onto the lender. The borrower will then pay the fixed rate to the counterparty. The counterparty adds its premium into the rate so that the borrower pays it over the life of the swap contract. The borrower does not pay an upfront premium, but depending on the relationship with the counterparty, the borrower often must post collateral.
The borrower will benefit when floating rates rise above the fixed rate, but they may lament entering the swap agreement if rates decline. To ensure the borrower continues to honor the contract, they typically must pledge collateral. If the borrower chooses not to uphold the swap, the counterparty can claim default and require a termination or buyout, and breakage or prepayment penalties will be due.
Swaps offer an alternative approach to interest rate risk protection with no upfront costs, allowing investors to conserve cash and move forward with confidence. The primary downside is that swaps are less flexible if the borrower opts to make an early exit from the asset or note, often as a response to declining rates.
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With an awareness of the capital markets, monetary policy and finance hedging techniques, borrowers and originators can confidently proceed with transactions. When a deal initially looks like the numbers don’t make sense, dig into due diligence, do what’s possible to raise additional equity, and research the available hedging techniques and products. This will provide a solution that brings economic risk to manageable levels and magnifies the upside for all parties to the transaction. ●