Response to the European Commission s public consultation Derivatives and Market Infrastructures

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1 Response to the European Commission s public consultation Derivatives and Market Infrastructures 1. Introduction The European Public Real Estate Association (EPRA) is the voice of the European publicly traded real estate sector. EPRA represents publicly listed property companies, (including REITs), the investment institutions who invest in the sector and the firms and individuals who advise and service those businesses. Between them our 200 members represent over 250bn of real estate investments. EPRA are also part of an alliance of global real estate organizations called REESA (the Real Estate Equities Securitization Alliance) who work together on common issues affecting real estate markets worldwide. In total, REESA represents over 1 trillion of real estate on a global basis. We are grateful for the opportunity to comment on these important proposals for the reform of the regulation of OTC derivatives markets. We have set out some general remarks below, and then provide specific responses to certain of the questions contained in the consultation document. In our response, we refer specifically to property companies whose shares are traded on the public markets, but our comments are also generally applicable to the corporate property sector as a whole, whether listed or unlisted. 2. Executive summary EPRA considers that a distinction must be made between derivatives used as a risk management tool for hedging real underlying risk to which the user is exposed, and derivatives used solely for speculation. On this point, our position is consistent with this of Rapporteur Werner Langen in the Parliament s own-initiative report on derivatives markets as adopted in June. Our overriding concern is that the proposals outlined in the consultation document may result in listed property companies, which are normal operating companies that use derivatives for risk management and hedging, potentially being treated as financial counterparties, with very damaging consequences for market stability and risk. The consequences for the publicly listed property sector of having to follow central clearing procedures would be severe and detrimental to the stability of the real estate sector as a whole: the use of derivatives to manage risk would be reduced, leading to greater vulnerability to market volatility in the property sector the impact for businesses with hedging positions could be insolvency. EPRA would like to work with the Commission towards ensuring that the boundary between financial and non-financial businesses is determined appropriately, and which correctly identifies listed property companies for what they are non-financial operating businesses that use interest rate hedging to reduce financial risk. European Public Real Estate Association Blvd de la Woluwe 62 Woluwelaan 1200 Brussels, Belgium T: +32 (0) F: +32 (0) EC Register of interest representatives ID#

2 3. EPRA s principal concerns Our principal concerns are as follow: (a) Listed property companies which use derivatives for risk management and hedging are liable to be treated as financial counterparties, with very damaging consequences for market stability and risk. This problem arises because of the reference to alternative investment funds managers under the AIFM Directive in the definition of financial counterparty. It is aggravated by continuing uncertainty regarding the precise scope of that Directive and by the gaps left between the proposed definitions of financial counterparty and non-financial counterparty. The AIFM Directive is often referred to as the hedge funds Directive, but its scope is both far wider than that, and uncertain around the margins. As discussed further below, whilst it is clear to us that listed property companies are normal operating companies and should be excluded from the scope of the Directive, the view of the Commission in this respect is unclear and it s all-encompassing approach to determining scope leaves the position for listed property companies in some doubt. The Commission has never provided a clear articulation of its intended conceptual scope or precise boundaries for the AIFM Directive. It is said to be all-encompassing, but it does not encompass all fund managers (the managers of UCITS, for example, are excluded), and it may apply to certain businesses such as joint ventures or even some property companies that are not fund managers at all. While real estate fund managers are clearly within the scope of the Directive (and at least the larger organisations in that sector know that), uncertainty persists about how the Directive might apply to other types of property businesses, including publicly listed property companies. While the Commission may feel tempted to treat alternative investment fund managers under the AIFM Directive as a proxy for hedge funds, that temptation should be resisted if undesirable consequences for non-financial end-users of derivatives are to be avoided. It is to be hoped that both the uncertainty and the errors in the scope of the AIFM Directive will be addressed within that Directive but the derivatives proposals should be capable of achieving their objectives in their own right and should not depend on the final form of the AIFM Directive. (b) In relation to risk mitigation for non-cleared contracts, the new regime must take account of non-cash security (such as underlying real estate assets) supporting the contract. While real estate assets are not as liquid as cash, it would not be appropriate to disregard a real estate security directly underpinning a property company s obligations under a derivative, or its real estate assets more generally, when laying down requirements for timely and accurate exchange of collateral and appropriate and proportionate holding of capital. 2

3 (c) Information and clearing thresholds for monitoring and regulating the use of derivatives by non-financial undertakings must recognise the specific characteristics of real estate assets. In particular, property assets (and thus related loans and the nominal principal of associated derivatives) can by their nature be very substantial; the swap counterparty is typically the lending institution, and the most usual form of derivative will seek to protect the investing business from rising interest rates. We believe that the systemic relevance of such derivatives should be low, even if the sum of net positions by counterparty per class of derivatives might be high. 4. Property companies are not financial businesses The business model of publicly listed property companies is underpinned by the provision of high quality accommodation and related services to businesses and individuals. Our member s core objective is to maximise returns to shareholders over the long term by providing a competitive product/service to the customer. This customer may be the tenant of the property, as well as (using the example of a retail shopping centre) the ultimate customer of the retail business, or (using the example of a commercial office complex) the employees of a corporate occupier. Owning and operating property requires active and intensive management. Property companies create value by actively managing and developing property to provide the environment from which modern business can operate. The management of a listed property company involves buying existing properties (empty buildings or buildings with leases already in place), buying buildings with the potential to develop or refurbish, the construction of new buildings for leasing, renting out existing buildings after refurbishment/or development, and selling buildings or land in order to recycle capital into new assets or developments. All of these functions will be overlaid by an evolving strategic objective determined and executed by the company s management. At site level, operating investment property involves intensive management of the existing portfolio of leases, property maintenance and related services such as tenant administration, engineering services, janitorial services, waste collection, pest control, fire protection, security, compliance with environmental regulation and the supervision of on-site and off-site staff and subcontractors. A typical property company will have an employee base including a team of asset and property managers who are responsible for these important functions. A publicly listed property company is no different from any other operating business. As well as the usual management and supervisory board structures, it also has accounting and tax departments and other administrative functions such as human resources and public relations that are required to run any publicly listed company. 3

4 Property companies are not financial undertakings as referenced in the Derivatives and Market Infrastructures consultation document. Real Estate Investment Trusts (REITs) in Europe are a particular type of publicly listed property company that are granted a special look-through tax status in return for meeting certain conditions - such as the annual distribution of a high proportion of distributable earnings from property rental income. The objective of this tax transparent status is to provide shareholders with an investment opportunity that is broadly equivalent to a direct investment in property, but in a form that is regulated, liquid and hence, unlike direct property investment, accessible to a broad spectrum of investors. The special conditions applying to REITs (such as minimum dividend distribution requirements) are in place to ensure that national governments continue to receive an adequate share of tax revenues in the form of withholding taxes, collected at the time of distribution rather than at the corporate level. 5. The use of derivatives by the commercial property sector Derivatives are essential for efficient pricing in the real estate debt market The existence of both fixed rate loans and floating rate loans combined with interest rate risk hedging as financing options for property companies is an essential part of the overall operational and pricing efficiency of the lending markets. Floating and fixed rate debt markets are not always equally efficient and investor demand for floating rate debt or fixed rate debt may make one more efficient than the other at any given time. Further, banks prefer to lend on a floating rate basis because they typically borrow on a floating basis - the European bank lending market is fundamentally a floating rate market, dependent on fluctuating rates like LIBOR and EURIBOR. Interest rate swaps therefore allow the borrower to achieve the benefits of a fixed rate, whilst allowing the borrower to pursue the lowest cost financing. The borrower also enjoys far greater flexibility to revisit its financing arrangements and its interest rate exposure where the loan and the interest rate hedge are separate than where the interest rate hedge is effectively embedded in a fixed rate loan. Property businesses as non-financial end-users of derivatives It is common for property companies to seek to access capital for their business partly through the debt markets and for the lending institutions to provide debt at a variable interest rate. Property companies thus seek to minimise financial risk by hedging against variations in the interest rate. In fact, it is commonplace for the lending institution to require the borrower to take out an interest rate swap so as to ensure that the borrower s relatively predictable rental income is sufficient to cover all or most of his debt service costs, even if interest rates rise. To the extent that interest rate hedging is put in place (it is common for it to cover 70% or 80% of the loan), these arrangements effectively equate to borrowing at a fixed interest rate, but are more cost efficient. 4

5 Figure 1 below shows the proportion of debt that is effectively fixed in this way for a selection of larger European listed property companies. Fig 1 - % debt exposure which is fixed debt (either fixed or effectively fixed through hedging) According to a survey of bank lending to UK commercial property in , for example, around 57% of an estimated total of 240bn- 250bn of loans outstanding had interest rate hedging in place, suggesting around 140bn of notional principal under interest rate swaps. Some 85% of the 59 lending organisations surveyed by the research said that they require interest rate hedging to be in place when originating new loans. Appendix I provides a more detailed illustration of the benefits of hedging, how the use of interest rate swaps achieves this, and why property companies achieve stable financing costs in this way as opposed to entering into a fixed rate loan. Appendix I also illustrates the detrimental effects that would arise from requiring the borrower to centrally clear OTC derivatives. While the use of derivatives in this way is very common across the property industry, overwhelmingly for hedging and risk management purposes, cash collateralisation is rare. Cash collateral is typically used where a property business pre-hedges, i.e. enters into a swap in anticipation of the leveraged purchase of a property in order to lock into swap pricing available before the property is acquired. Where the property business owns property funded by a loan and related swap, it is common for the loan and swap to be secured on the property, with the swap ranking pari passu with, or senior to, the loan. Having said that, it is also common for listed property companies to raise corporate debt which is not secured on particular assets and which may have a swap attached with no underlying property security or cash collateral. Many listed groups in other industry sectors borrow and hedge interest rate or currency exposure in the same way. This form of borrowing (and associated use of derivatives) is still fundamentally non-financial in nature. Overall, therefore, the use of derivatives by property businesses of all kinds is very common, and is overwhelmingly motivated by the desire to enhance the stability and predictability of cash flows. In fact, for property companies, debt financing, and the corresponding requirement to apply strategies to reduce financing risks, can play a much more significant role than in other non-financial sectors due to the capital intensive nature of the industry where considerable investments are committed over a long time period, often spanning different economic cycles. 1 The De Montfort University Commercial Property Lending Market Report (year end 2009), available on request. 5

6 It is vital that this is recognised by the new Derivatives regime, with all property businesses being regarded, in the first instance, as non-financial counterparties and only in extremely unusual cases involving non-hedging positions in derivatives - being subjected to central clearing. Central clearing, and the margining requirements that go with it, would be at least as damaging for property businesses as they would be for other non-financial users of derivatives for hedging purposes, undermining the cash flow predictability which motivates the use of these instruments and increasing the risk of business failures, systemic risk and market instability. Exposing the property sector to those risks by imposing margining requirements would indirectly affect the financial system as well, because of the substantial exposure that many important European financial institutions have to real estate. Responses to specific questions Section I, 4 (Non-financial undertakings) Question: Do stakeholders share the general approach set out above on the application of the clearing obligation to non-financial counterparties that meet certain thresholds? Answer: We agree with the proposed use of an information threshold, provided that it is defined in a way that recognises the specific characteristics of the property industry and its use of derivatives for hedging purposes. However, we consider that a clearing threshold should apply only to non-hedging derivatives. In principle, we support the proposition that thresholds might be used to identify cases where non-financial end-users of derivatives should disclose appropriate information relating to their derivative positions and cases where such users should be subject to central clearing. However, it is critical that the operation of any such thresholds is correctly calibrated and that the clearing threshold never results in derivatives entered into for hedging purposes being forced into central clearing and margining. The consultation document is not at all clear about how such thresholds might be set, stating that they would be defined at a further stage. The specific attributes of real estate businesses and their use of derivatives need to be properly understood so that they do not result in relevant thresholds being exceeded where the consequences of exceeding a threshold are not justified by the systemic risk posed by those derivatives. For example, a large property business might borrow 1bn for five years to fund the acquisition of a 2bn real estate asset, and enter into a related five year interest rate swap with a notional principal of 1bn (with both the loan and the swap secured on the asset). If that transaction is entered into in a moderately high interest rate environment to protect the property business from further increases in interest rates, but interest rates fall during the life of the swap (as they did in the credit crunch), the property business may have a very substantial negative net position on the swap. Because of the way it uses interest rate hedges, the property business may have a number of similar swaps in place (for different assets and loans), all moving out of the money together when interest rates fall. We do not believe that it would be appropriate for the thresholds to require clearing obligations to apply in such circumstances (and we are doubtful whether even information obligations 6

7 should apply). The property business is using derivatives to improve the stability and predictability of its cash flows and the derivatives are supported by the security of the underlying real estate assets. Indeed, the systemic risk posed by those derivatives would be dramatically increased and market stability threatened if the property business were required to post cash collateral to reflect their market value. We accept that the principles relating to thresholds for non-financial undertakings should apply to property businesses where they enter into derivatives which are not supported by the security of underlying real estate. However, we would expect those thresholds to be set in such a way as should rarely be exceeded by such businesses in practice. We also agree that the thresholds should apply to determine whether the relatively rare cases where property businesses use derivatives in a more speculative way are systemically significant. Central clearing and margining should never be required in relation to derivatives designed to hedge risks and improve the stability and predictability of cash flows. Any clearing threshold should only ever apply to non-financial businesses in respect of non-hedging derivatives positions. That would be consistent with the approach which we understand is being adopted in the equivalent reforms in the United States, where there is a specific disregard of [substantial positions in swaps] held for hedging or mitigating commercial risk in assessing whether a non-financial business is a major swap participant. Section I, 5 (Risk mitigation techniques for non-cleared contracts) Question: Do stakeholders share the principle and requirements set out above on the risk mitigation techniques for bilateral OTC derivative contracts? Answer: We support these proposals, provided the requirements for collateral recognise security provided over assets such as real estate and do not focus exclusively on cash. The overwhelming majority of OTC derivative contracts entered into by property businesses are fundamentally risk management and hedging instruments and as such should remain outside mandatory clearing and free from the margining requirements that mandatory clearing would entail. Accordingly, the risk mitigation techniques applicable to bilateral contracts are highly relevant to property businesses. We do not object in principle to improvements in the way operational and credit risk is measured, monitored and mitigated by financial counterparties and (subject to the comments made above) non-financial counterparties exceeding the clearing threshold. However, we are very concerned about the disproportionate and damaging implications of such improvements on property businesses which use derivatives for hedging purposes, if the improvements are not properly focused. The fact that a derivative contract entered into by a property business has a negative market value will be irrelevant for both the property business and the swap provider, except where the property business seeks to terminate or restructure its loan early (in which case the cost of breaking the swap will need to be covered by any proposal). The purpose of the swap is to ensure that the anticipated revenues of the property business are sufficient to cover its debt service obligations and if the loan and the swap are of the same duration (as is usually, though not always, the case) and run to term, the residual liability arising from the swap at the end of the loan will be zero. For this reason, the risk posed by the swap should always be low. 7

8 The risk posed by swaps used by property businesses is particularly low when as is usually the case the swap supports a property-backed secured loan and itself benefits from the security (ranking equal with or senior to the loan). Provided that the total leverage on the asset is not excessive, it is difficult to see why any additional collateral (such as cash) should ever be required in such cases in addition to the existing security. The most obvious impact of such a requirement would be to threaten the financial viability of the borrower, reducing market stability. Accordingly, while we acknowledge that property businesses that enter into corporate-level hedged borrowings must fall to be treated in the same way as other non-financial end-users of derivatives from the point of view of risk mitigation, we would strongly argue that where derivatives support secured loans and themselves benefit from the security of an underlying real estate asset, that security must be recognised by any risk mitigation strategy. Section V (Technical reference glossary of definitions) financial counterparty means investment firms as defined in Directive 2004/39/EC, credit institutions as defined in Directive 2006/48/EC, insurance undertakings as defined in Directive 73/239/EC, assurance undertakings as defined in Directive 2002/83/EC, reinsurance undertakings as defined in Directive 2005/68/EC, undertakings for collective investments in transferable securities (UCITS) as defined in Directive 2009/65/EC, institutions for occupational retirement provision as defined in Directive 2003/41/EC and alternative investment funds managers as defined in Directive 2010/ /EC; non-financial counterparty means a legal entity established in the European Union other than financial counterparties; Question: Do stakeholders agree with the definitions set out above? Answer: We would like to work with the Commission to qualify the reference in the financial counterparty definition to the Alternative Investment Fund Managers Directive, so that fundamentally non-financial end-users such as listed property companies are not wrongly treated as financial counterparties, with potentially very damaging consequences. We believe that the inclusion in the proposed definition of financial counterparty of alternative investment funds managers as defined in [the AIFM Directive] is problematic. We appreciate that the Commission believes that certain fund managers which are alternative investment fund managers within the AIFM Directive (and not caught by any of the other components of the financial counterparty definition) should be treated as financial counterparties for the purposes of the derivatives proposals. However, the scope of the AIFM Directive is broad and uncertain and qualifications are needed to avoid wrongly treating many ordinary businesses as financial counterparties. Joint ventures - It is common for property businesses to develop and invest in large real estate assets jointly, pooling skills, expertise and balance sheet capacity. All of the two or three businesses which might typically be involved would participate actively in the operation and management of the joint venture. We believe that such joint ventures cannot possibly be described as alternative investment funds and should be entirely outside the scope of the AIFM Directive. Joint ventures also arise when a single property business secures an investment from an institution such as a pension fund alongside its own investment in a joint 8

9 venture vehicle, but manages the joint venture alone on behalf of itself and the institution. We believe that this sort of arrangement, too, is not what the AIFM Directive should be targeting. Unfortunately, the way the AIFM Directive has been drafted means that both of these kinds of joint venture would probably be treated as internally managed alternative investment funds. We hope that this problem will be addressed but, if it is not, the proposed definition of financial counterparty would compromise the ability of property businesses to improve the stability and predictability of their cash flows for the benefit of their investors by using derivatives for risk management purposes. It should be clear from the foregoing paragraphs that the AIFM Directive is not a reliable short cut for setting the scope of key provisions of the legislative proposal for the reform of derivatives regulation. We would like to work with the Commission to refine this component of the definition so that businesses which use derivatives overwhelmingly for non-financial, hedging purposes are not forced into central clearing and margining. Gareth Lewis EPRA, Director of Finance T +32 (0) gareth.lewis@epra.com Blvd de la Woluwe 62 Woluwelaan 1200 Brussels Belgium T +32 (0) F +32 (0) EC Register of interest representatives ID#

10 Appendix I How OTC Derivatives Help Borrowers reduce risk Example of an Actual Hedge Used by a Real Estate Company The purpose of this Appendix is to: 1. provide an example of how an OTC derivative is used to mitigate interest rate risk, 2. explain the beneficial features of an OTC derivative relative to conventional lending alternatives, and 3. identify the detrimental effects of requiring the borrower to centrally clear or exchange trade OTC derivatives. Background In 2007, a real estate company ( the Real Estate Company ) refinanced the maturing debt on its property, an office building. Because tenants of the building entered into fixed rate leases, the Real Estate Company also wanted to use long term fixed rate debt on its financing. It evaluated proposals to put fixed rate debt in place and compared those proposals to putting floating rate debt in place combined with an interest rate swap to synthetically fix the rate on the debt. The Real Estate Company concluded that floating rate debt with an interest rate swap provided the Real Estate Company with lower financing costs and more favourable prepayment terms. Following is a profile of the loan and the interest rate swap, followed by discussion as to the benefits of the interest rate swap. Loan: Amount: 640,000,000 Lender: Bank Real Estate Group an affiliate of Bank Derivative Group Loan Rate: 1 month LIBOR % Loan: 10/1/2007 9/1/2017 Collateral: Secured by mortgage held on the property Hedge: Amount Hedged: 640,000,000 Counterparty: Bank Derivative Group an affiliate of Bank Real Estate Group Hedge Rate: 5.50% Hedge Index: 1 month LIBOR Hedge Period: 10/1/2007 9/1/2017 Collateral: Secured by same mortgage held on the property Benefits of OTC Derivative The swapped floating rate debt presented clear benefits to the traditional fixed rate financing. These benefits were as follows: 1. Perfectly Matched Cash Flows: The derivative cash flows are perfect in offsetting the risk to rising interest rates on the floating rate financing. This is demonstrated in the table below, which shows how, no matter how much LIBOR increases, the 10

11 Appendix I borrowers interest expense remains fixed at 6.40%. This is shown in greater detail in the attached schedule of payments. 2. Pricing Efficiency: The swapped floating rate debt resulted in a lower rate than conventional fixed rate debt. The savings was approximately 6 million over the life of the loan. This is because floating rate markets and fixed rate debt markets are not always equally efficient. Investor demand for floating rate debt or fixed rate debt may make one more efficient than the other at any given time. Further, banks prefer to lend on a floating rate basis because they typically borrow on a floating basis. Interest rate swaps allow for the borrower to achieve the benefits of a fixed rate, while allowing the borrower to pursue the lowest cost financing. 3. Favourable Prepayment Terms: In the event of Prepayment, the swapped floating rate debt presented the following benefits. a. Ability to receive payment upon termination of swap if rates increase. b. Ability to incur lower prepayment penalty than with conventional fixed rate debt if rates stay the same or decrease. i. If rates stayed the same, under the conventional fixed rate financing, the Real Estate Company would incur a prepayment penalty of approximately 44 million if prepaid halfway through the financing. Loan might be prepaid, for example, if the borrower opted to sell the building. ii. If the Real Estate Company prepaid the swap at the same point in time, the prepayment cost would be 0. This is because the prepayment cost of swapped floating rate debt solely relates to changes in interest rates, and not the borrower s credit spread. Detrimental Impact of Central Clearing & Exchanges If central clearing or exchanges had been required in 2007 when this financing was put in place, the borrower would have faced several detrimental impacts. 1. Inability to Use Property as Collateral: The interest rate swap is secured by the property, just as the loan is. In the event the borrower ceased to be able to make its payments on the loan, the lender would be able to recoup its losses on both the loan and the swap through the value of the property. To the extent the building value had diminished so substantially that it ceased to be able to cover the lender s losses on 11

12 Appendix I the loan and swap, the lender s losses would be no less than the losses that they would have incurred on a fixed rate financing. 2. Upfront Collateral Requirement: The project would have needed to post approximately 19.2 million (equal to 3% of notional amount) in upfront cash collateral 3. Ongoing Mark-to-Market Collateral: Today, based upon current swap rates, the Real Estate Company would currently have posted an additional 100 million to secure the negative value of the swap, even though such obligation would be paid over the course of the remaining 8 years. When interest rates were at their lowest point, the collateral that would be required to be posted would have equalled an additional 180 million. The graph below shows the value of the swap over time. 4. Impact on Investment and Job Creation: A requirement to set aside almost 200 million in cash to satisfy margin requirements would have a material impact on the Real Estate Company s ability to enter into new construction projects and property acquisitions. As such, these margin requirements would limit the growth prospects of the company and, therefore, the ability for the Real Estate Company to increase hiring and maintain its workforce. 5. Cost Impact of Collateral Posting: Reserving working capital to post as collateral would cause the Real Estate Company to have a dramatically higher financing cost than if it were able to use the property to secure the derivative. The total interest rate of 6.40% increases to as high as 8.70% when taking into account the lost opportunity to invest that capital at a 10% rate of return. If the Real Estate Company forewent an opportunity to invest those funds at a 5% rate of return, its maximum interest rate would increase to 7.50%. At 20%, the debt cost would increase to 11.00%. 6. Limitations on Customization: If clearinghouses or exchanges do not develop hedging alternatives tied to 1-month LIBOR, the Real Estate Company would have been unable to perfectly lock its cash flows on the debt obligation 12