Real Estate Case Study: Debt Ratio
A public real estate company specializing in asset management in the hospitality sector.
Our client had paid down a significant portion of their floating rate line of credit, leaving them with a fixed/floating rate debt ratio higher than they desired. With hotel assets essentially re-pricing daily, the client wanted to increase their floating rate exposure on the liabilities side to better match the characteristics of their assets.
We discussed entering into a receive-fixed swap to rebalance their fixed-floating mix. A secondary benefit of this strategy was that it allowed them to reduce their current interest expense due to the steepness of the yield curve; the receive fixed swap synthetically transformed a higher fixed rate obligation into a lower floating rate obligation, based on an historically low current LIBOR setting. Because this client is a public company, there were significant accounting considerations in determining which source of underlying debt to hedge, with the goal being to minimize any potential earnings impact the swap could have. As a fair value hedge, it was important to consider the term of the debt and the characteristics of their available bonds and/or mortgage debt. Common features, such as prepayment options, equity clawback provisions, and call options can create inefficiency or potentially preclude a client from applying hedge accounting and can lead to earnings volatility if not properly addressed.
The client was able to execute an effective hedge that achieved their desired fixed-floating profile. While the interest rate environment at the time made receive-fixed swaps an attractive product for many companies looking for upfront interest savings, in this case the company was positioned to take advantage of these savings as part of a larger risk management strategy.