Hedging Toolkit: How Multifamily Sponsors Combat Interest Rate Risk.
by Max Sharkansky Managing Partner at Trion Properties
In late July, the Federal Reserve (Fed) raised the target range for the federal funds rate to 2.25% to 2.50%, its second consecutive hike of 0.75% and fourth increase since March. Looking ahead, it’s unclear whether the Fed will scale back the size of its hikes at its next meeting in September or maintain its all-out effort to rein in inflation.
Rising interest rates put real estate investors on edge—understandably so, given that interest rate risk plays an important role in determining the performance of a real estate portfolio. Climbing rates make the long-term fixed-rate debt more costly. Short-term floating-rate debt is also impacted: SOFR and LIBOR—rates that often serve as the reference indexes to which spreads are tied for floating-rate loans—both closely track the federal funds rate. As such, sponsors with unhedged floating-rate debt will likely see their loans become increasingly expensive as the Fed hikes rates.
Real estate sponsors, however, aren’t rendered defenseless. Several effective hedging strategies are within their toolkits for managing debt during periods of rising rates. Here we look at interest rate caps and interest rate swaps, two popular strategies for hedging risk associated with floating-rate loans. We also touch on the effects of interest rate volatility.
Interest rate caps
We can think of a rate cap as a tool to lock in a maximum interest rate. Borrowers with floating-rate loans benefit by knowing their interest expense won’t exceed a certain amount, while still having the opportunity to benefit from any decline in rates.
After lining up a floating-rate loan, a borrower can purchase a rate cap from a third-party provider for a specific notional amount, strike price, and term. If the reference index of the floating-rate loan rises above the strike price, then the third-party provider is liable for the excess interest expense. For example, a $25 million, 3-year, 2% strike cap would pay out if SOFR exceeds 2% over the next 3 years. This caps the borrower’s loan coupon at 2% plus the loan spread.
We can see how rate caps help borrowers manage the costs of floating-rate loans—but lenders also benefit. Rate caps mitigate the concern that an increase in rates could inhibit a borrower’s ability to make growing interest payments. It’s no surprise, then, that rate caps are commonly required by lenders to close new floating-rate bridge and construction loans.
Borrowers typically pay a one-time, up-front fee to the rate cap provider. As shown below, the cost of a rate cap goes up as the strike prices come down, the term extends, and/or the notional increases. Lender requirements can also impact cap pricing. While a cap with a low strike price and long term affords the borrower more protection, sponsors must carefully assess the associated costs, as they may impact the portfolio or asset returns.
Rate caps typically have no prepayment penalties, meaning the cap can be terminated at no cost to the borrower.
A “plain vanilla” interest rate swap is a derivative contract between two counterparties who agree to exchange one stream of interest payments for another. As illustrated below, a real estate borrower can use a swap to exchange a floating-rate payment for a fixed-cost payment. The borrower thereby secures protection against rising interest rates. If rates decline, however, the borrower won’t benefit, as the obligation to pay the fixed rate remains.
For real estate sponsors, one important swap consideration is related to early termination. The mark-to-market value of a swap shift constantly based on the forward curve, which reflects the market’s forecast for future rates. If a sponsor enters an interest rate swap and pays off its loan early, it will need to settle the swap contract at the current market value. If the forward curve reflects expectations for rising rates, the swap can be an asset to the borrower. The swap could be a liability if rates are expected to decline, resulting in a breakage cost for the borrower.
Interest rate volatility
Rising rates have been the headline focus for many real estate investors—but elevated interest rate volatility is another important dynamic impacting real estate transactions and risk management.
Measures of interest rate volatility are climbing to notably high levels, including the ICE BofAML MOVE Index, an indicator of costs for Treasury options. The MOVE Index recently reached a ten-year peak as traders rapidly adjust their views on future rate hikes, the path of inflation, and a potential recession.
As benchmark rates and forward curves exhibit increased volatility, real estate borrowers face additional risk during the window between getting a deal under contract and closing. In a volatile environment, a lot can change during these in-between weeks, resulting in significant changes in financing costs. Sponsors who are aware of this volatility can work to mitigate risk by analyzing a wide spectrum of interest rate moves and preparing for varying costs.
Our approach to navigating a rising rate environment At Trion Properties, our disciplined financing process is rooted in our commitment to delivering outsized returns without taking outsized risks. In today’s environment, this means we are fixing rates when possible and using caps and swaps to hedge risk on floating-rate debt. We have also purchased multiple assets in the last year with assumable long-term fixed-rate debt. In terms of managing volatility, we are underwriting a larger range of potential leverage costs and continually positioning our portfolio to succeed in any interest rate scenario.
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