Apartments at CityCenterDC
Author: Paul Elsen
Interest Rate Swaps are one of the tools that commercial real estate borrowers can use to manage the risk associate with floating rate loans. Often times, borrowers choose to enter swaps with the rationale that they are “free”, especially when compared to an interest rate cap that typically requires an upfront payment. However, swaps are certainly not free, and can have a significant cost or “fee” if not negotiated carefully.
What fee is that, you might ask? Well, we are talking about the swap fee, credit charge, or mark-up. It goes by many names, but it is ultimately the overhead and profit a lender embeds into the swap rate in excess of the mid-market swap rate. The mid-market swap rate, which reflects a swap provider’s cost, is the rate at which two credit-worthy banks would transact if one wanted to pay fixed and the other wanted to receive fixed in the same swap structure. The fixed rate a real estate borrower agrees to pay in a swap, then is the combination of this mid-market rate and the credit charge the bank will add to the rate at execution.
How does this happen? Don't lenders have to disclose all of their fees?
Let’s consider an example. A bank issues a term sheet for floating rate loan at 1 month LIBOR plus a loan spread, say 2.00%. The term sheet states that the borrower will be required to swap the floating rate to a fixed rate of interest and that the current all-in rate would be, say, 5.0%. (This all-in rate is equal to the 2.00% loan spread plus the fixed swap rate.) On the surface this may seem okay, but what is not disclosed is the fee the bank plans to embed in the swap. If the bank’s mid-market swap rate is 2.70%, they have added 30 basis points to the swap rate. On a $25mm, 7-year loan this amounts to a present value of about $490,000. Dodd-Frank requires banks designated as swap dealers to disclose their mid-market swap rate at the time a swap is entered into, but not when a term sheet is provided to a prospective borrower. This means that in our example, a borrower may only learn at closing the bank is charging 30 basis points on the swap. Of course, it’s probably too late then to question a swap fee of 30 basis points, at least without delaying the closing.
As mentioned, Dodd-Frank requires swap dealer banks to disclose their mid-market swap rate at swap execution, but they will tell you, and it’s true, that the Dodd-Frank mid-market swap rate does not accurately reflect their cost to provide the swap. A swap is a credit intensive product, and, as such, there is a cost for a bank to face a real estate borrower. Chatham models thousands of trades every month-end, and for many of them we calculate a Credit Valuation Adjustment or “CVA” that takes into account the potential for losses due to a counterparty default. The CVA we calculate roughly reflects a bank’s cost to provide a swap. For an L+2.00% borrower, this cost is roughly 10 basis points on a 7 year term. The additional swap fee (20 basis points) goes to cover the cost to maintain a derivatives desk and, of course, to profit.
What can you do?
We know that reliable access to real estate debt capital is the lifeblood for most of our commercial real estate clients, so what can be done that won’t damage your lending relationships? First, discuss the credit charge for any swap with potential lenders before you sign a term sheet, and ask them to disclose it in the term sheet. You can tell them that you are trying to assess the whole picture of the proposed loan before making a decision, and that the swap credit charge is important in that analysis. Agreeing on a swap credit charge, expressed in basis points, will allow both parties to know what all-in loan rate will be even as the underlying mid-market rate fluctuates between term sheet signing and closing. While this does not prevent the rate from potentially rising during this time, you will know the final rate you pay is what you negotiated. In our experience, if the swap credit charge isn’t agreed to upfront, it is likely your rate will go up, at least in accordance with market movements, but you may not get a corresponding movement if rates fall.
You take into account all the fees, expected interest costs, proceeds, covenants, and prepayment characteristics, when selecting a lender, right? Don’t leave out of your analysis what could be the biggest fee of all!