Interest Rate Swaps & How to Use Them
Published 01-09-2019
A bank may suggest that a borrower use an interest rate swap (IRS) in conjunction with an adjustable-rate mortgage (ARM) instead of a traditional ARM or fixed-rate commercial real estate loan product when interest rates are low but expected to rise in the future. This hedges future interest rate risk and can have certain advantages over typical fixed rate mortgage products. Typically borrowers will choose a swap rather than a typical ARM or fixed rate portfolio loan for the following reasons:
To get a lower all-in interest rate and payments
To protect against future interest rate increases
To lessen or eliminate potential prepayment penalties
WHAT IS AN INTEREST RATE SWAP?
A swap is a type of interest rate derivative (IRD) that takes the form of a contractual agreement separate from the real estate mortgage; it can help manage the uncertainty associated with the floating interest rates of ARMS and hedge risk by exchanging the ARM’s floating mortgage payments for the contract’s fixed swap rate (see illustration under “How an Interest Rate Swap Works” below). Interest rate swaps can be used for financing a single commercial property or a portfolio of properties. The rate on the swap contract floats until closing and is fixed once the swap is executed; the fixed rate will depend upon market conditions when the swap is executed.
BENEFITS OF INTEREST RATE SWAPS
Swaps can be executed at any time during the swap contract, for any length of term during that contract, and on any portion of your floating rate financing (subject to regulatory requirements, credit approval, and any restrictions under your financing documents and swap documents).
If you make a prepayment on your financing, the swap can be used to hedge other floating rate obligations (unless the swap is required to terminate under the contract’s terms, which may include early termination fees, outlined below).
Under a swap contract, the borrower may be entitled to compensation if the swap was executed and fixed at a lower rate than prevailing fixed swap rates (see example below).
RISKS OF INTEREST RATE SWAPS
If a fixed swap contracted is executed and interest rates drop, the Borrower foregoes the benefit of lower interest rates.
Negative interest rates may have a material impact on the performance of the swap (i.e. some swap contracts don’t have a “floor” of 0%, which may have serious financial consequences for the borrower, explained below).
If the executed swap is terminated before the stated maturity date, termination fees may apply. This includes if the anticipated financing (i.e. ARM) does not close or your financing is prepaid; it will not relieve you of your swap obligations, and you may be required to pay an early termination fee.
Bottom Line: Locking in a fixed rate when interest rates are low may be an attractive hedging strategy. However, if floating rates stay low, fall, or become negative over the life of the swap, then it may have been cheaper, in hindsight, not to have hedged against rising interest rates by entering into the swap. This is a product for financially savvy borrowers and should not be used by those that are extremely risk-adverse or that want a “set it and forget it” loan product.
HOW AN INTEREST RATE SWAP WORKS
Alternative A:
With a floored interest rate swap, Borrower will pay a fixed rate to the swap contract holder and Lender will pay Borrower a variable rate based on the one month LIBOR rate (floored at 0%) + 1.75% for the term of the swap, subject to the terms of the swap contract; a negative LIBOR rate would not increase the cash payments owed by Borrower (due to the floor).
Borrower will separately make variable interest payments on its ARM based on the one month LIBOR (floored at 0%) + 1.75%; the amount of the payments depends on the amount of the financing hedged, as stated in the swap contract. Below is an example in which the floating rate and other terms of the swap and financing match, which is not guaranteed (see “Unmatched Terms” below). Because the swap is a separate contract from the financing, if there is any change to the financing (including the rate index or loan spread), the swap does not automatically adjust to the new terms, and the overall interest expense will increase or decrease accordingly.
Alternative B:
With an unfloored interest rate swap, Borrower will pay a fixed rate to the swap contract holder and Lender will pay Borrower a variable rate based on the one month LIBOR (unfloored) + 1.75% for the term of the swap, subject to the terms of the swap contract; the LIBOR rate is not floored at 0.0% and therefore a negative rate will increase the swap cash payments owed by Borrower (see ''Negative Interest Rates'' below).
Borrower will separately make variable interest payments on its ARM based on 1 month LIBOR (floored at 0.0%) + 1.75%; the amount of the payments depends on the amount of the financing hedged, as stated in the swap contract. For further details see “Unmatched Terms” under the Important Information section. Below is an example in which the floating rate and other terms of the swap and financing match, which is not guaranteed (see “Unmatched Terms” below). Because the swap is a separate contract from the financing, if there is any change to the financing (including the rate index or loan spread), the swap does not automatically adjust to the new terms, and the overall interest expense will increase or decrease accordingly.
PREPAYMENT/EARLY TERMINATION FEE STRUCTURE
As illustrated in the examples below, if a swap is terminated prior to its scheduled maturity date for any reason (including if Borrower and Lender mutually agree to terminate the swap early), then:
Borrower may owe an early termination payment to the Lender if, on the date of termination, the fixed rate of the swap is higher than prevailing fixed rates for an identical swap with the same remaining term.
Borrower may receive an early termination payment from the Lender if the fixed rate of Borrower’s swap is lower than prevailing fixed rates on the date of termination for an identical swap with the same remaining term.
Alternative A:
Loan/Swap Structure: Borrower pays 5.17% and receives 1 month LIBOR (0% floor) +1.75%
Term/Amortization: 10/20
Loan Amount: $1,275,000
Alternative B:
Loan/Swap Structure: Borrower pays 5.07% and receives 1 month LIBOR (no floor) +1.75%
Term/Amortization: 10/20
Loan Amount: $1,275,000
OTHER FEATURES
Borrower Eligibility for a Swap Product:
The Borrower and each of the swap guarantors must meet certain eligibility requirements under the Commodity Exchange Act in order to enter into a swap agreement on a privately-negotiated basis without exchange trading or clearing requirements applying.
Swap Trading Relationship Documentation ("STRD"):
The ISDA Master Agreement is an industry-standard form used to document the contractual relationship between the Borrower and the swap contract holder (usually the Lender). Published by the International Swaps and Derivatives Association ("ISDA"), the Master Agreement outlines payment and legal obligations, early terminations, transfers, governing law and other contractual terms for interest rate swaps. The Master Agreement’s Schedule contains credit-related provisions and other individually-tailored terms. Once these documents are completed, a Confirmation for the transaction will be sent for execution, which becomes part of the Master Agreement. Additional documentation, including a legal opinion and board resolutions, may be necessary to complete this process.
Legal Entity Identifier:
Parties to swap contract transactions are required to have a Global Markets Entity Identifier ("GMEI"), which allows regulators to track swaps across markets, products and regions. Information on how to obtain a GMEI is available at https://www.gmeiutility.org/.
Election of End-User Exception:
Absent an exemption (such as the “End-User Exception”), swaps subject to mandatory clearing are required to be cleared on a derivatives clearing organization ("DCO") under US law. Clearing involves replacing the swap contract holder (usually also the Lender) with a DCO as a counter-party, which will require establishing a clearing relationship with a futures commission merchant ("FCM"). In order to enter into swaps with the swap contract holder on an uncleared basis under the End-User Exception or any other exception, additional documentation and/or information will be required.
Risks to Consider:
While an interest rate swap may be used for hedging purposes to reduce or eliminate certain risks associated with your commercial real estate financing, the effectiveness of the product may depend upon holding these assets to maturity and not reducing or disposing of all or any of the real estate during the term of the swap. If a swap contract is terminated early, or if the Borrower reduces or disposes any or all of the underlying collateral before the transaction matures (i.e. selling the underlying real estate or prepaying an ARM hedged with a swap), then depending on the nature of the transaction, the Borrower may incur a substantial loss or may receive little to no hedging benefit. The Borrower may also incur a substantial loss if it enters into a swap contract in anticipation of a loan closing that does not materialize (see “Independent Obligation” below).
Independent Obligation:
To the extent that any swap contract described in this information may be used for hedging purposes, the swap transaction is a separate and independent obligation and would not be contingent on whether any financing closes, is outstanding or repaid, or for other financing-related events. Additionally, if the Borrower provides any collateral or other credit support to secure the transaction or financing, then the Borrower would only be entitled to the release of such collateral if certain conditions in the related collateral agreement are completely satisfied or an alternative agreement is reached with the Lender.
Unmatched Terms & Conventions:
If the principal amount or duration of financing differs from that of a swap contract used to hedge the financing, the Borrower could be exposed to risk of loss from over-hedging or under-hedging. If any other economic terms or characteristics of the financing differ from those of the swap contract, then unanticipated accounting issues or tax liabilities may occur. If fair value accounting applies to the swap contract, the Borrower may have to reflect unrealized gains or losses on the balance sheet and/or income statement (by “mark-to-market” changes). If hedge accounting applies, ineffectiveness in the swap contract which results from such differences may likewise need to be reflected in your financial reports. Conventions used in the loan and swap markets may differ, and the Lenders have no obligations to ensure that the swap and loan match perfectly, even if they provide you with both products, so it’s important to ask questions to understand any differences.
Example: if the method for determining a loan’s adjustable rate differs from that for a swap’s adjustable rate (i.e. definition of or the reset timing (e.g., 1-month or 3-month) for the London Interbank Offered Rate (LIBOR), the dates or times at which LIBOR is set, the number of days in the payment periods, any applicable fall-back floating rate, or the adjustable rate rounding convention), then the loan floating rate payments may be different from those of the swap. Such divergence occurs by convention or as the result of contractual differences.
Negative Interest Rates:
In order to place a 0% floor on LIBOR or any other floating benchmark rate of a swap transaction, express wording must be included in the swap contract documentation; a 0% floor is not included unless mutually agreed upon between the parties, which would be reflected in the swap confirmation. If the floor does not exist and a Floating Amount is negative under an interest rate swap, the Floating Rate Payer does not make such payment. Instead, the Fixed Rate Payer pays the absolute value of the negative Floating Amount in addition to the Fixed Amount. (See §6.4 of the 2006 ISDA Definitions, as amended). Typically there is an increase in the price of the swap (as reflected in the fixed rate) if the borrower wishes to have a swap with a 0% floor.
Projections, Forecasts & Other Data Are for Informational Purposes Only.
CLD does not guarantee the accuracy, reliability or completeness of this information and makes no representation or warranty, express or implied, with respect thereto. This information is subject to change without notice, does not constitute trading or investment advice or research, and has not been prepared in accordance with any laws or regulations designed to promote the independence of research. Historical data, past trends and past performance do not reflect or guarantee future results. Financial projections and economic forecasts are based on hypothetical assumptions about uncertain future market conditions and events and therefore should not be relied upon in connection with any asset, liability, transaction or otherwise, including any decision whether or when to invest or hedge or to acquire or dispose of any asset, liability or transaction. Projections or forecasts may not materialize, and reliance thereon could result in substantial losses. It is impossible to predict whether, when or to what extent rates, values and other economic factors will rise or fall, and there could be sharp differences between projections or forecasts and actual results. CLD makes no representation or warranty that actual results will conform to any projection or forecast and is not responsible for any loss or damage arising out of any reliance on or use of such information.
This information (collectively, the “Materials”) is provided by CLD (“we,” “our,” or “us”) for general information about the transactions described in the Materials. Although we believe that market data and other information contained in the Materials is reliable, it is not warranted as to completeness or accuracy, is subject to change without notice, and we accept no responsibility for its use or to update or keep it current. The Materials are not an offer or commitment for any products or transactions. A Lender’s willingness to enter into any transaction is subject to final credit approval, agreement on transaction terms and compliance to their satisfaction with all applicable legal and regulatory requirements, including onboarding and swap trading relationship documentation. Terms, rates, prices and structures in the Materials are indicative only, and should not be relied upon as the terms, rates, prices or structures on which a Lender or anyone else would be willing to enter into, terminate or transfer a transaction with you, or relied upon for any other purpose. Actual rates and prices may be higher or lower depending on market conditions at the time of execution. Any historical information provided in the Materials is for information only, and past performance may not be relied upon as a guarantee of future results. Examples in the Materials are hypothetical only and are not a prediction of future results. There are frequently sharp differences between projections or forecasts and the actual results achieved.
