Commercial real estate (CRE) borrowers often encounter interest rate swaps in conjunction with mortgage/debt financings. For many bank lenders, a swap, offered with a floating-rate loan, is an efficient way to provide fixed-rate debt. Often, these swaps must be secured by the underlying property being financed and, as a result, swaps on mortgage debt are commonly executed directly with the lender or members of the lending group (if it is a syndicated loan). As many aspects of swap economic and legal terms may be negotiable with the lender and can impact investment returns, many CRE investors choose to engage an advisor to assist in structuring and negotiating swaps, even if they are done directly with a single lender. The following are some of the key benefits of utilizing an advisor on a lender-required swap.
Why use an advisor?
A borrower’s total swap rate generally consists of the two components below. The borrower’s synthetic all-in fixed-rate will be the sum of these components plus the loan spread.
- Mid-market rate: A market driven rate based on current market expectations for LIBOR resets over the term of the swap. This fluctuates over time with market movements but should largely be an objective and verifiable number.
- Credit charge: Negotiated, deal-specific charge based on the perceived credit quality of the borrower entity and the profit expectations of the lender’s swaps desk (distinct from the loan returns). This may be thought of as an additional component of the loan spread, albeit one paid to the lender’s swap desk, not their lending group.
An advisor can assist a borrower in breaking their lender’s component pricing into these parts and provide transparency at closing, including:
- Assisting the borrower in negotiating the bank’s credit charge: Agreeing on a swap credit charge (expressed in basis points) upfront and as a part of the overall loan terms will enable both parties to know that the final rate a borrower pays is what was negotiated even as the underlying mid-market rate fluctuates over time.
- Assisting the borrower in executing the swap at loan closing: At the time of swap execution/loan closing, the negotiated credit charge is added to the then prevailing mid-market rate and the swap rate (and all-in loan coupon) is locked in. While many large banks are required by law to disclose their mid-market rate, many smaller banks are not, and some banks will include a small mid-to-offer spread that may range from a few tenths of a basis point to 1-2 basis points.
An advisor can routinely save the borrower at least several basis points in the overall fixed loan rate, and, in many cases, quite a bit more.
Economic risk analysis and structuring
While many borrowers rightly think of swaps and the underlying mortgage debt as part of the same overall transaction, and in most cases the swap can not exist without the underlying loan, they are typically documented as two separate, but interrelated contracts. If structured without consideration for the underlying loan terms or the underlying asset plan, a swap may result in unintended consequences over the life of the investment. An advisor identifies and analyzes these risks to help borrowers weigh the costs and benefits of potential structures. Examples include:
- Loan floors: Most floating-rate CRE loans now include a floor on LIBOR (often 0%), which prevents the interest rate on the loan from falling below a certain threshold even if LIBOR falls. If a swap on such a loan is not structured with the floor in mind, the borrower creates the risk of their interest expense increasing if LIBOR falls below the floor rate.
- Prepayment risk: Swaps do not have upfront costs, but they can be future liabilities and result in breakage costs if terminated early. The amount of this swap breakage is the present value difference between the borrower’s contracted swap rate and the prevailing mid-market swap rate for the remaining swap term (the replacement rate). If the borrower’s rate is above the replacement rate, the swap will be a liability. Conversely, if the borrower’s rate is below the replacement rate, the swap will be an asset.
Documentation review and negotiation
Swaps are documented separately from a loan agreement using an industry standard set of documents known as an ISDA. While often presented to borrowers by their lender as a boilerplate document, parts of the document may be negotiated to be more or less favorable to the borrower, particularly with respect to default and termination events and ties to other investments the owners of the borrower may have. While some outside counsel that represent borrowers have expertise in this area, many others do not. An advisor will review and coordinate other swap-related documentation such as:
- Pre-trade Dodd-Frank/EMIR compliance forms with the bank
- LIBOR fallback language in loan agreements in conjunction with counsel
- Trade documentation (i.e. swap confirmation) to ensure the bank has accurately summarized the trade terms after execution
Why use Chatham?
Chatham advises on $2.9 billion of hedged notional every day, giving us significant visibility into market credit charges for different lenders and financing profiles. We leverage this market presence to reduce the borrower’s all-in synthetically fixed loan coupon and to quantify the dollar value of the credit charge being paid to the lender’s swaps desk.
During execution, Chatham validates the mid-market rate to which the credit charge is being added and advises on the appropriateness of any mid-to-offer spread based on then current market conditions.
Economic risk analysis and structuring
Chatham works with borrowers to quantify potential breakage costs in consideration of the plans for the underlying asset and provides what-if scenarios to help quantify possible outcomes. This often includes evaluating embedding options in swaps that allow borrowers to prepay the underlying debt without any potential swap breakage.
Documentation review and negotiation
Chatham reviews and negotiates over 3,000 ISDAs annually, giving us unmatched insight into which provisions are negotiable with different lenders and what may be appropriate for different sponsors and borrowing situations, allowing a borrower to quickly get to market terms independent of or in conjunction with a borrower’s outside counsel.
Derivatives experts with unmatched perspective
Chatham brings transparency to each of these components and leverages its expertise and market awareness to ensure that the borrower gets best possible terms and has no surprises over the term of the swap. Chatham is the market leading advisor for interest rate swaps, executing over 7,000 swaps every year. And with over 700 employees globally, 3,000 clients, and $750 billion in transaction volume annually, Chatham helps real estate investors maximize their value in the capital markets, every day.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal/notices/.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved. 20-0203