Hedging Variable Rate Exposure in a Commercial Real Estate Debt Portfolio Authors Dan Hampton, Senior Vice President, Managing Director and Head of U.S. Commercial Real Estate bmo Harris Bank Timothy Huang, Vice President, Financial Products bmo Capital Markets Published 8.15.2013 IN THIS WHITE paper: Mechanics of interest rate swaps and caps Customization options for interest rate derivatives Examples from the commercial real estate industry
Executive Summary The size and complexity of today s commercial real estate (CRE) portfolios demand sophisticated and costeffective ways to both raise capital and manage financial risks. While traditional fixed-rate term loans provide cost certainty, they lack the flexibility required by many borrowers and can be more costly than floating-rate loans. Conversely, a capital structure comprised entirely of floating rate debt may carry an unacceptable level of interest rate risk for borrowers, even though it may provide more flexibility. Fortunately, today s financial markets provide CRE borrowers with the means to maximize flexibility while managing debt service costs and market risks. In the current lending environment, a growing number of CRE borrowers strategically choose to utilize floatingrate loans paired with interest rate derivatives an interest rate swap or an interest rate cap to provide more flexibility and preserve cost certainty. This approach allows borrowers to source the cheapest form of available capital, while still managing interest rate risk inside specific parameters. In this white paper, Dan Hampton, Senior Vice President, Managing Director and Head of US Commercial Real Estate for BMO Harris Bank and Timothy Huang, Vice President, Financial Products, BMO Capital Markets, discuss the mechanics of swaps and caps and examine their application by CRE borrowers to help manage interest rate risk in a variety of situations. 2
Tools Used to Manage Interest Rate Risk Financing commercial real estate has always been a challenging proposition, but today, borrowers have access to more flexible options for managing portfolio risk than ever before. Tools such as interest rate swaps and caps can provide borrowers with a flexible capital structure with tailored interest rate protection, providing cost certainty across a range of economic environments. Before using swaps and caps to manage debt costs, borrowers should first understand how these instruments work. Interest Rate Swap Mechanics An interest rate swap is a standalone contractual agreement between two parties (in most cases a bank and a borrower) in which the parties agree to exchange cash flows according to a specific set of calculation parameters, including notional principal size, floating index, or frequency, over a defined period of time. The cash flows exchanged as part of a swap agreement combined with those paid on an underlying floatingrate loan matching terms as appropriate will result in the same cash flows as if the CRE borrower had Example #1: Swaps Scenario: A borrower finances a property or a portfolio of properties with a floating-rate term loan. If left unhedged, the borrower s cost of funds will increase or decrease as the floating-rate index rises or falls during the life of the loan. The diagram below illustrates how a swap paired with a floatingrate term loan creates fixed-rate financing for a borrower. In this arrangement, the borrower makes interest payments on its loan, subject to changes in the variable rate index (in this case, LIBOR). In each payment period under the swap agreement, the borrower will make or receive a net payment. Result: If LIBOR is below the contracted fixed swap rate, the borrower pays the difference between LIBOR and the swap fixed rate. If LIBOR sets above the contracted fixed swap rate, the borrower receives the difference between LIBOR and the swap fixed rate. When the net payment on the swap is combined with the loan payment, the borrower s out-of-pocket interest cost is equal to the fixed rate on the swap plus the loan credit spread. Over the term of the hedge, as LIBOR rises and falls, the borrower s cost of funds remains fixed. Borrower Fixed Swap Rate Floating Rate LIBOR Floating Rate LIBOR + Credit Spread Bank Debt Effective All-in Financing Cost = Fixed Swap Rate + Credit Spread 3
executed a fixed-rate-loan facility. This creation of synthetic fixed-rate debt is the most common way CRE borrowers use interest rate swaps. Because a swap is a contractual agreement to pay a stream of future cash flows, an early termination of this agreement is likely to result in a termination payment. However, unlike a fixed-rate loan where an early termination can only result in a payment by the borrower, an early termination of a swap Example #2: Caps Scenario: The diagram below shows that a borrower has a floating-rate term loan and purchases a cap at a specific strike to set a maximum interest rate cost. During the term of the loan, the borrower pays floating-rate LIBOR on the loan even if LIBOR exceeds the strike. Result: For any interest period during the life of the cap where LIBOR exceeds the strike level, the borrower will receive a payment from the bank to compensate them for the increase in LIBOR in excess of the cap strike. This reimbursement effectively sets a maximum debt-service cost at the cap strike level plus the loan credit spread. could result in a payment to either party. If interest rates fall, or fail to climb as forecast, the borrower will owe a fee upon early termination. Alternatively, if interest rates climb, borrowers could receive a payment upon an early termination event. Interest Rate Cap Mechanics An interest rate cap is a contractual agreement between two parties wherein one party (the bank) agrees to reimburse the other party (the borrower) if interest rates (LIBOR or Prime) rise above a particular threshold (cap strike) during a specific period. The borrower pays an upfront premium to the bank for this protection. The amount of this premium varies depending on the parameters of the cap, which may include notional principal size, term of protection, or strike level. A cap acts like an insurance policy against rising rates, and like an insurance policy, will cost more for a higher degree of protection (i.e. lower strike level) or a longer term of protection (i.e., five years versus three years). Caps are commonly used by CRE borrowers who have an appetite for floating-rate debt but have a maximum tolerable cost of funds. Provided a borrower has made all required premium payments, a cap is an asset owned by the borrower. Because of this fact, in an early termination event, the value of the cap to the borrower can only be positive (or zero). This means that the borrower will Borrower Cap Premium Bank Debt Increases in LIBOR above strike Floating Rate LIBOR + Credit Spread Effective Worst Case All-in Financing Cost = Cap Strike + Credit Spread 4
either be able to terminate the cap early without further payments or will in fact receive a payment if the market value of the cap is greater than zero. Flexible Solutions Diversifying a Debt Portfolio Borrowers with a large portfolio of commercial real estate often have a target fixed-float mix for their debt capital structures. These borrowers can utilize swaps and caps to help achieve this mix at either the individual loan level or across a portfolio of debt. For example, through a swap a borrower can fix a specific percentage of a new lending facility. Alternatively, a borrower could apply the same approach to a portfolio of loans using one macro hedge. This tactic allows a borrower to achieve a targeted fixed-float mix while retaining the flexibility to choose the most cost-effective funding sources. Pre-Hedging Future Term Funding Construction loans that convert to term debt at project completion are common CRE financing structures. Traditionally, a borrower will not know its cost of funds on the term debt until close to project completion. This means that a borrower s costs remain uncertain and final project economics are exposed to rising rates during the construction period. One tool available to help manage this exposure is a forward starting swap. A forward starting swap allows a borrower to enter into a swap agreement today with an effective starting date set at some point in the future. Using a forward starting swap in conjunction with a construction loan allows a borrower to lock in the interest rate on the take-out financing today, rather than wait until construction is completed. This allows a borrower to accurately forecast future interest expense and provide cost certainty. Customizing Protection Levels Many CRE borrowers have a lower tolerance to rising rates during the early years of a financing, as cash flow is dedicated to the stabilization of the project. Once stabilization has occurred, borrowers may have the ability to absorb higher interest expense without threatening the viability of the project. Purchasing an interest rate cap with a high degree of protection (i.e. low strike) can address this concern. However, as previously discussed, purchasing a 5
low-strike interest rate cap can be expensive. Fortunately, because interest rate derivatives allow for high degrees of customization, the cap can be structured to map to a borrower s risk parameters. For example, a borrower who expects to have an increased tolerance to rising rates in the later years of a project could purchase a step-up-cap. This variation on the standard interest rate cap carries a high degree of protection (i.e. low strike) in the early years of the structure and a lower-degree of protection (i.e. high strike) in the later years. The cost of a step-up cap will generally be lower relative to the cost of a cap with a constant degree of protection at a low strike level. In this way, a borrower can achieve a degree of protection well-suited to specific needs of the project, while minimizing the cost of obtaining protection. Moving Forward with Swaps and Caps The preceding examples showcase two of the many applications of swaps and caps by CRE borrowers to manage risk. What makes these tools compelling is their high degree of customization, which allows borrowers to design a hedge that delivers a specific level of protection for any situation or rate environment. However, it is important for borrowers to understand the products, the associated benefits/costs, and the potential risks and rewards in any hedging strategy. Borrowers can look to leverage their financial institutions as a valuable resource for education and to assist in the implementation of a hedging strategy. An excellent resource that borrowers should consider is the knowledge and expertise available from BMO Harris Bank. Through a close partnership between your banking team and individuals from our Financial Products group, we can determine the best instruments and structures to address the specific needs and risk tolerance for your project or portfolio. Ultimately, borrowers should not hesitate to ask questions to ensure they are comfortable with available products. After becoming familiar with these products, borrowers can use interest rate derivatives to realize short- and long-term risk management benefits and enhance bottom-line results. Visit us online at ResourceCenter.bmoharris.com/realestate for more industry insights 6
About the Authors Dan Hampton Dan is a Senior Vice President, Managing Director and Head of US Commercial Real Estate for BMO Harris Bank. He joined Harris N.A. as a result of the First National Bank & Trust of Indiana (FNBT) acquisition in 2007. He is responsible for appropriately aligning people and capital resources to take advantage of opportunities in the market. Prior to joining FNBT, Dan was Managing Director of Indiana Real Estate with Geneva Capital Group, a Chicagobased mortgage banking firm, for eight years. Overall he has 30 years of banking experience, with the past 25 in commercial real estate and commercial banking. Dan is a graduate of the Graduate School of Banking at the University of Wisconsin, the Graduate School of Commercial Lending at the University of Oklahoma, The National School of Real Estate Finance, and the National School of Compliance Management. He also attended the University of Dayton. For more information from Dan Hampton, read his Insights blog bmoharris.com/danhampton. To reach Dan Hampton: dan.hampton@bmo.com 317.269.1370 Timothy Huang Timothy is a Vice President in the Financial Products Group at BMO Capital Markets in Chicago. He joined the bank as an analyst in 2006 on the Canadian Financial Products team, focusing on interest rate and currency risk management structuring for Canadian corporate clients. In 2008, Timothy transferred to the U.S., where he now provides hedge structuring and marketing services to the bank s real estate and industrial commercial banking clients. Timothy holds a Bachelor of Applied Science in Computer Engineering from the University of Toronto and a Master of Business Administration from the University of Toronto s Rotman School of Management. To reach Timothy Huang: timothy.huang@bmo.com 312.845.4010 7
About BMO Harris Bank BMO Harris Bank s Commercial Real Estate Group knows that successful real estate firms need a reliable banking partner with an extensive platform of products and services, a solid capital base to ensure the safety of their deposits, and the ability to fund their needs through the economic cycles. The group is comprised of experienced and dedicated banking teams designed to provide creative solutions tailored to each customer s unique requirements. The Corporate Real Estate team serves the extensive needs of REITs, REOCs, private equity funds, and institutionally sponsored firms throughout the United States. The Middle-Market Real Estate team offers the local expertise necessary to address the unique demands of private developers and investors transacting on a local, regional, and national basis. Additionally, we have the resources and expertise to provide access to government lending programs, which can offer significant benefits in community development projects. Deposit and loan products and services provided by BMO Harris Bank N.A. Member FDIC. BMO Harris Bank is a trade name used by BMO Harris Bank N.A. BMO Harris Bank is part of BMO Financial Group, a North American financial organization with 1,600 branches and approximately $557 billion in assets (as of the first quarter, 2013). Visit us online at bmoharris.com/commercialbank This material has been prepared with the assistance of employees of BMO Capital Markets and BMO Harris Bank N.A. (collectively BMO ) who are involved in sales and marketing efforts. Accordingly, it should be considered to be a solicitation of derivatives business generally and not a research report that reflects the views of disinterested research analysts. Notwithstanding the foregoing, this material should not be construed as an offer or the solicitation of an offer to sell or to buy or subscribe for any particular product or services (including, without limitation, any commodities, securities, or other financial instruments). We are not soliciting any specific action based on this material. It is for the general information of our clients. It does not constitute a recommendation or a suggestion that any investment or strategy referenced herein may be suitable for you. It does not take into account the particular investment objectives, financial conditions, or needs of individual clients. Nothing in this material constitutes investment, legal, accounting, or tax advice, or a representation that any investment or strategy is suitable or appropriate to your unique circumstances, or otherwise constitutes an opinion or a recommendation to you. BMO is not providing advice regarding the value or advisability of trading in commodity interests, including futures contracts and commodity options or any other activity which would cause BMO or any of its affiliates to be considered a commodity trading advisor under the U.S. Commodity Exchange Act. This material is not to be relied upon in substitution for the exercise of independent judgment. Any recipient of these materials should conduct its own independent analysis of the matters referred to herein. The recipient should seek advice based on its particular circumstances from its own independent financial, tax, legal, accounting, and other professional advisors. These materials are confidential and proprietary to, and may not be reproduced, disseminated, or referred to, in whole or in part, without the prior consent of BMO. Information presented in this material has been obtained or derived from sources believed by BMO to be reliable, but BMO does not guarantee their accuracy or completeness. BMO assumes no responsibility for verification of the information in these materials, and no representation or warranty is made as to the accuracy or completeness of such information. BMO assumes no obligation to correct or update these materials. These materials do not contain all information that may be required to evaluate any transaction or matter and information may be available to BMO and/or its affiliates that is not reflected herein. BMO Capital Markets is a trade name used by the BMO Investment Banking Group, which includes the wholesale arm of Bank of Montreal and its subsidiaries BMO Nesbitt Burns Inc. in Canada, BMO Capital Markets Corp. in the U.S., and BMO Capital Markets Ltd. in the U.K. BMO Harris Bank N.A. is not a registered swap dealer. As a result, BMO Harris Bank N.A. is not subject to the regulations applicable to registered swap dealers. Borrowers entering into swaps with BMO Harris Bank N.A. will not be covered by the protections afforded by such regulations, including risk disclosure and other informational requirements, margin segregation requirements, and other provisions. BMO (M-bar rounded symbol) Capital Markets is a trade-mark of Bank of Montreal, used under license. 8