Another week, another 75 basis points mounted onto the Federal Reserve’s benchmark interest rate—and the more that all commercial lenders will eventually be charging.
That’s tough sledding in summer for commercial real estate. Variable rates get reset, refinancing gets more expensive, and there may be deals that are no longer viable.
Marcus & Millichap has a new report on hedging techniques, specifically interest rate swaps and caps. “The Federal Reserve’s commitment to raising interest rates, renewed by higher-than-anticipated CPI inflation in May, has brought these options back to the forefront of many borrowers’ minds,” the report noted.
A swap gives the option of trading a floating rate for a fixed one after a specified period of time. Caps put a top limit on how high a floating rate can go. But if used at the wrong time or under adverse conditions, these techniques can clamp down on someone’s posterior just as they think they’re seated on some safety.
As the current report notes, a cap also only pays its own way if the interest rate on a loan rises enough that the cap prevents additional costs. If rates don’t hit the trigger point, the borrower could spend money unnecessarily—though the point of a hedge is always risk management with the understanding that it’s a form of insurance.
As one example, interest caps prices are currently crushing transactions that otherwise would have happened. “We had somebody who had an interest rate cap, but when they signed the deal two months ago to when they could get the deal closed recently, the price tripled,” Thompson Coburn partner Josh Mogin told GlobeSt.com at the end of May. “They had to take $1.2 million to buy a cap they were planning to spend $300,000 to $500,000.”
“There’s simply a lot more going on in CRE than underwriting to a spread over the cost of capital,” John Chang, Marcus & Millichap senior vice president and national director of research and advisory services, told GlobeSt.com last month. “When there’s a shortage of capital, cap rates tend to rise and the yield spread tends to widen, but where there’s a lot of capital, both equity and dent, the spread tends to tighten.”
Technically, both cap and swap pricing are based on market forward expectations of the Secured Overnight Financing Rate, or SOFR. “By executing a swap, the floating rate loan from a bank synthetically becomes fixed, at more or less the average interest rate of the forward curve at that time over the swap term,” the report says. “If the borrower were to prepay their loan sometime in the future, the unwind could be an asset or a liability, depending on where the swap rate is at that time for the remaining term.” Swaps can also only have a bank as a counterparty, so if the lender is a debt fund or private money source, that option isn’t available.
The ultimate costs of these hedges depend on the shape of the SOFR forward curve, something that’s been steep of late. “While many borrowers have given little thought to them over the past decade due to a low interest rate and low-cost environment, today’s forward curve makes it essential that borrowers understand these hedging instruments and the risks and costs associated with them,” the firm said.