Swapping Out the Best Rates to Reduce Risk
When choosing your financing vehicle, it’s advantageous to consider swap rates to hedge against a portfolio’s floating-rate risk.
- Feb 08, 2012
By Marcelo Bermúdez,
President, Figueroa Capital Group Inc., a subsidiary of Charles Dunn Co.
When you choose your financing vehicle to leverage your commercial real estate investment, deciphering fixed, floating and swap rates can be an onerous task for the uninitiated. Traditional step-down pre-pays are certainly available with lenders, but uncertain times call for additional strategies to minimize risk and limit potential expenditures when at all possible. Swaps can provide this kind of hedge for any existing floating-rate risk in a commercial real estate portfolio.
There are five basic types of swaps – currency, rate, credit, commodity, and equity. The most common type is a rate swap, which trades variable-rate risk for fixed to ensure even cash flows and loan payments. Some of the best features of this derivative include that it is “portable,” meaning you are buying a financial instrument for your property portfolio to hedge against other floating-rate obligations, not just a bell or whistle for a particular loan. Swaps can also make you money if the relevant market swap fixed rates have risen since the time you have purchased your contract. This is a great strategy to consider when comparing it to yield maintenance (where the note is paid off entirely and there is a percentage prepay penalty) or defeasance (the substitution of collateral ensures the lender attains its yield requirement).
Swap rates are determined by underlying projections of whatever the chosen index, say, the 30-day LIBOR, is going to average. The mathematics are identical to a bond purchase and acts very much like an insurance policy – you may never have to use, but it’s good to know you have it there. Like insurance, you have some opportunity cost associated with the contract, such as foregoing very low rates in this market. (I just quoted a client a rate of below 3 percent for a one-year LIBOR deal). Historically, general market rates are low and attractive. The Fed continues to watch out for inflation and has recently alluded to keeping rates where they are while the economy recovers. With the presidential election coming and consensus that rates must rise over time, it may be a good strategy to consider entering into a swap contract for your portfolio as job reports continue to improve. When the Fed raises rates, they normally do so quickly and often.
The actual rate quote will include the swap rate as previously described along with a spread for the risk associated to the contract by the lender. So how can you make or lose money? If you need to terminate your contract prior to a scheduled maturity, you can look at the market swap rate at termination versus the contractual swap rate as an example:
Contracted Swap Rate – 4.96 percent
Swap Rate: 2.21 percent
Loan Spread: 2.75 percent
Net Fixed Rate: 4.96 percent
Market Swap Rate – 3.21 percent or 1.21 percent
Swap Rate: 3.21
Change: 1.00 percent (In the money)
Swap rate: 1.21
Change -1.00 percent (Out of the money)
In 2012, you purchase your 10-year swap contract against the one-year LIBOR. Five years down the road, you decide to sell your property. Assuming rates have increased, you would actually receive a payment from your swap contract. More importantly, if you were to compare this to a traditional prepayment scenario using Treasurys where you will always be paying out, your cost to terminate can save you as up to 300 percent. For most investors, this is the best feature of a swap since it helps to remove the handcuffs of a required outflow of cash to satisfy bank yield requirements. Consider swaps the next time you need to finance or refinance a property to hedge your bets and even make a little more money in the process.
Marcelo Bermúdez is the president of Los Angeles-based Figueroa Capital Group, a subsidiary of Charles Dunn Co., a firm that focuses on structuring debt and equity solutions for commercial real estate investment properties.