Presenting a live 90-minute webinar with interactive Q&A Interest Rate Hedges in Real Estate Finance: Placing Swaps, Caps, and Collars on Floating Rate Loans Understanding Pricing and Trade Confirmations, the ISDA Master Agreement, Counterparties, Current Regulation of Derivatives WEDNESDAY, FEBRUARY 22, 2017 1pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Jeffrey H. Koppele, Partner, Dentons US, New York Mark Heimendinger, Of Counsel, Lowndes Drosdick Doster Kantor & Reed, Orlando, Fla. The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10.
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Introduction Jeffrey H. Koppele Partner Dentons US LLP New York, NY D: 212-768-6916 jeffrey.koppele@dentons.com Mark E. Heimendinger Of Counsel Lowndes, Drosdick, Doster, Kantor & Reed, P.A. Orlando, FL D: 407-418-6271 Mark.Heimendinger@lowndes-law.com February 22, 2017 5
Agenda Introduction: Interest Rate Risk in Real Estate Financings Hedging Interest Rate Risk: Rate Caps and Interest Rate Swaps Placing the Rate Cap or Swap Hedge Specific Documentation Loan Agreement Terms Relating to Hedge Regulatory Issues: Dodd-Frank February 22, 2017 6
Interest Rate Risk in Real Estate Loans A commercial mortgage loan often bears interest at a floating rate. Floating rates can rise quickly at any time. Rental income of the property owner/borrower generally changes gradually. A spike in interest rates is thus a risk for borrower (and lender). February 22, 2017 7
Mitigating Interest Rate Risk Lenders often require the borrower to mitigate the risk of interest rate volatility. A hedge is a form of "derivatives contract." Derivative: an agreement whose value is derived from the value or amount of an underlying index, asset or event. Here the index is an interest rate, usually 1-, 3- or 6-month LIBOR. February 22, 2017 8
Rate Cap The most common hedge in commercial real estate finance is a rate cap. Essentially an interest rate insurance policy with an upfront premium. Rate cap provider pays the excess, if any, of LIBOR over a specified Strike Rate. Notional amount typically equal to loan principal amount and may amortize; duration usually equal to initial loan term, excluding extensions. Rate Cap Cashflows Borrower LIBOR - Strike Upfront Payment Rate Cap Provider February 22, 2017 9
Combining Rate Cap and Loan Rate Cap sets a cap on the Borrower's effective interest rate under the loan. Lender typically determines the strike rate for the rate cap based on the property's expected cashflows/interest coverage. Borrower's effective interest rate is capped at Strike + Spread. Combining Rate Cap and Loan Cashflows Lender LIBOR X + Spread Borrower X LIBOR - Strike Rate Cap Provider Loan Rate Cap February 22, 2017 10
Advantages and Disadvantages of Rate Caps Advantages No ongoing borrower payment obligations under the rate cap (after payment of upfront premium). Borrower will benefit from declines in the floating rate. Borrower may receive, but will never be obligated to make, a termination payment. Typically assignable by borrower. Disadvantages Rate cap requires upfront premium. Cost increases exponentially with duration. Rate caps typically limited to three years. February 22, 2017 11
Borrower Cost Capped Whether LIBOR Rises or Falls Assumptions Loan interest rate: LIBOR + 1% LIBOR at closing: 2% Strike Rate on Rate Cap: 3% Borrower net cost capped at Strike + Margin 4% If LIBOR goes up, Rate Cap proceeds fund Borrower's increased interest cost. Example: LIBOR increases to 6% Borrower pays Loan interest rate: 6% + 1% = 7% Borrower receives from Rate Cap Provider: 6% - 3% = 3% Borrower net borrowing cost: 7% - 3% = 4% If LIBOR goes down, cashflow from property funds Borrower's interest cost. Example: LIBOR decreases to 1% Borrower pays Loan interest rate: 1% + 1% = 2% Borrower receives from Rate Cap Provider: Borrower net borrowing cost: 2% 0% (LIBOR less than Strike Rate) February 22, 2017 12
Interest Rate Swaps A swap is an exchange of a floating interest rate (e.g., LIBOR) for a fixed interest rate (e.g. 2.5%). Typically no upfront payment is required. Fixed rate will be a swap rate determined by the swap provider at the time of the trade (not selected by borrower or lender). Notional amount and duration are typically the same as for a rate cap. Fixed Rate and Floating Rate payments are netted against each other. Swap Cashflows Borrower LIBOR Fixed Rate Swap Provider February 22, 2017 13
Combining Swap and Loan Swap converts Borrower's floating rate obligation to a fixed rate. If LIBOR rises, Borrower receives cash under swap, pays higher loan interest rate. If LIBOR falls, Borrower pays cash under swap, pays lower loan interest rate. Borrower's effective financing cost: Fixed Rate plus Loan Spread. Combining Swap and Loan Cashflows Lender LIBOR X + Spread Borrower LIBOR X Fixed Rate Swap Provider Loan Swap February 22, 2017 14
Advantages and Disadvantages of Swaps Advantages No upfront payment required. Longer durations available. Fixed/swapped rate will not change over time. Disadvantages Borrower does not benefit from decline in floating interest rate. Borrower has ongoing payment obligations. Therefore, swap provider typically requires collateral or other creditworthiness. Two way termination payments are possible. Typically not assignable by borrower. February 22, 2017 15
Creditworthiness/Collateral Issues re: Swaps Borrower has ongoing payment obligations under a swap. Swap Provider will request to be secured party. Identity of the swap provider: Lender vs. loan syndicate member vs. unrelated party Intercreditor issues, even where Lender and Swap Provider are same entity. Consider requiring Borrower to use an affiliate to enter into swap. Avoids giving swap provider a security interest in the property. February 22, 2017 16
Disparate Objectives of the Parties to Rate Caps Lender robust cap Borrower minimize cost Rate Cap Provider high-volume, low-profit transaction Parties' disparate objectives can and frequently do result in risks for the Lender and Borrower. Many of these risks may be minimized. February 22, 2017 17
Rate Cap Provider Downgrade Rate Cap Risks Cap Provider bankruptcy or insolvency Rate Cap typically includes a "downgrade" provision: Cap Provider credit rating must exceed a specified threshold at closing. If Cap Provider rating drops below a specified trigger, Cap Provider must either post collateral or replace itself. If Cap Provider rating drops below a second trigger, Cap Provider must replace itself (and must post collateral until replacement is accomplished). Certain Cap Providers use parent guarantor to provide the necessary rating. February 22, 2017 18
Placing a Rate Cap Rate caps: Because rate caps do not require any collateral, borrower may purchase rate cap from any hedge provider that meets the lender s ratings requirements. Best pricing for rate cap typically achieved through an auction. Borrower's hedging advisor typically prepares a bid package and sends it to prospective hedge providers to solicit interest for the auction. Often, between 2-4 financial institutions agree to participate in the auction. On day of trade, hedging advisor holds recorded calls with each bank to accept their bids. The rate cap is generally awarded to the lowest bidder. February 22, 2017 19
Placing a Swap Swaps: Greater challenge regarding pricing. Borrower has ongoing payment obligations, so swap providers typically require collateral. However, lenders typically will not permit an unaffiliated hedge provider to have a security interest in the loan collateral. Borrowers thus are generally compelled to execute swaps with the lender. To ensure fair rate fixing, hedging advisor will negotiate with lender/swap provider for a specific number of basis points over published swap rates. On day of trade, hedging advisor holds a recorded conference call with lender/swap provider, to: Review trading screen where agreed-upon swap rate is published, Discuss the swap rate, and Upon agreement, confirm that swap trade is executed. February 22, 2017 20
Hedge Specific Documentation Hedge Term Sheet/Bid Package Recorded phone call during which trade is executed Trade Ticket Hedge Confirmation ISDA Master Agreement and Schedule to Master Agreement February 22, 2017 21
Hedge Term Sheet/Bid Package Bid Package Typically prepared by hedging advisor. Borrower and Lender should take a firm interest in the bid package. Confirm that confirmation conforms to bid package. Defined terms in hedge should match defined terms in Loan Documents (e.g., floating rate, rounding, business day, payment date, strike rate, maturity date). February 22, 2017 22
Recorded Phone Call to Execute Hedge Generally done on day of, or within a day prior to, loan closing. Real estate attorney typically not involved in the trade phone call. February 22, 2017 23
Trade ticket Hedge provider generates trade ticket immediately after hedge is executed on recorded phone line. Very short form document recording the primary elements of the hedge. February 22, 2017 24
Hedge Confirmation Detailed confirmation of the executed rate cap or swap. Should match the term sheet/bid package. Hedge provider typically prepares confirmation within several days after trade execution. February 22, 2017 25
Loan and Hedge Documentation Documents Affecting Hedge Agreement Loan Application Loan Agreement/Promissory Note Collateral Assignment of Hedge Bid Package Trade Ticket Hedge Documentation Dodd-Frank Protocols ISDA Master Agreement Schedule Confirmation(s) ISDA Definitions -- or -- "Long-form Confirmation Hedge Provider parent guaranty, if needed for ratings requirement Hedge Provider legal opinion February 22, 2017 26
Selected Loan Agreement Provisions re: Hedge Conditions Precedent re: Hedge Agreement Broad outline of hedge terms, e.g., rate, term, notional amount Swap provider consent to collateral assignment Hedge reasonably satisfactory to Lender (or Agent) Borrower Covenants Maintain hedge agreement over specified term Replace hedge upon swap provider downgrade Hedge covering loan extension period Lender consent to modifications or termination of hedge agreement Borrower obligation to pay interest unaffected by hedge agreement February 22, 2017 27
Selected Loan Agreement Provisions re: Hedge Failure to maintain hedge constitutes a borrower event of default An event of default under the hedge is typically a borrower event of default Application of hedge proceeds In general Upon hedge event of default or termination event Waterfall Borrower swap payments to lender/hedge provider Borrower swap payments to unaffiliated hedge provider Additional Interest Borrower swap obligations typically denominated as additional interest Mortgage secures borrower s additional interest obligations February 22, 2017 28
Loan Provisions Relating to Hedge Calculations Floating Rate in Loan Agreement and Hedge Should Match Notional Amount Fixed Stepdown Overhedging: Optional or Mandatory Partial Breakage Breakage February 22, 2017 29
Regulatory Issues: Dodd Frank Dodd-Frank Title VII Regulation of Over-the-Counter Swaps Markets Dodd-Frank can have a significant effect on hedges, particularly where a swap, rather than a rate cap, is used. Key issues: Eligible Contract Participant (ECP) Borrower and every co-obligor and guarantor of swap cashflows must qualify as an ECP Generally, to qualify as an ECP an entity must have: Total assets of at least $10 million, or Net worth of at least $1 million, if swap if is in connection with its business or hedging its assets or liabilities "End User" Clearing and Margin Exemptions Swap Reporting - obligation of the Swap Dealer February 22, 2017 30
Q&A Final Thoughts Questions & Comments February 22, 2017 31