interest rate hedges in real estate finance: placing swaps...

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Presenting a live 90-minute webinar with interactive Q&A

Interest Rate Hedges in Real Estate Finance: Placing

Swaps, Caps, and Collars on Floating Rate Loans Understanding Pricing and Trade Confirmations, the ISDA Master Agreement,

Counterparties, Current Regulation of Derivatives

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

WEDNESDAY, FEBRUARY 22, 2017

Jeffrey H. Koppele, Partner, Dentons US, New York

Mark Heimendinger, Of Counsel, Lowndes Drosdick Doster Kantor & Reed,

Orlando, Fla.

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Introduction

February 22, 2017

Jeffrey H. Koppele

Partner

Dentons US LLP

New York, NY

D: 212-768-6916

[email protected]

5

Mark E. Heimendinger

Of Counsel

Lowndes, Drosdick, Doster, Kantor &

Reed, P.A.

Orlando, FL

D: 407-418-6271

[email protected]

Agenda

February 22, 2017

• Introduction: Interest Rate Risk in Real Estate Financings

• Hedging Interest Rate Risk: Rate Caps and Interest Rate Swaps

• Placing the Rate Cap or Swap

• Hedge Specific Documentation

• Loan Agreement Terms Relating to Hedge

• Regulatory Issues: Dodd-Frank

6

Interest Rate Risk in Real Estate Loans

February 22, 2017

• A commercial mortgage loan often bears interest at a floating rate.

• Floating rates can rise quickly at any time.

• Rental income of the property owner/borrower generally changes gradually.

• A spike in interest rates is thus a risk for borrower (and lender).

7

Mitigating Interest Rate Risk

February 22, 2017

• Lenders often require the borrower to mitigate the risk of interest rate volatility.

• A hedge is a form of "derivatives contract."

– Derivative: an agreement whose value is derived from the value or amount

of an underlying index, asset or event.

– Here the index is an interest rate, usually 1-, 3- or 6-month LIBOR.

8

Rate Cap

February 22, 2017

• The most common hedge in commercial real estate finance is a rate cap.

• Essentially an interest rate insurance policy with an upfront premium.

• Rate cap provider pays the excess, if any, of LIBOR over a specified Strike Rate.

• Notional amount typically equal to loan principal amount and may amortize;

duration usually equal to initial loan term, excluding extensions.

Borrower Rate Cap

Provider

LIBOR - Strike

Upfront Payment

Rate Cap Cashflows

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• Rate Cap sets a cap on the Borrower's effective interest rate under the loan.

• Lender typically determines the strike rate for the rate cap based on the

property's expected cashflows/interest coverage.

• Borrower's effective interest rate is capped at Strike + Spread.

Combining Rate Cap and Loan

February 22, 2017 10

Rate Cap Loan

Lender Borrower Rate Cap

Provider

LIBOR - Strike LIBOR + Spread X X

Combining Rate Cap and Loan Cashflows

Advantages

• No ongoing borrower payment

obligations under the rate cap (after

payment of upfront premium).

• Borrower will benefit from declines

in the floating rate.

• Borrower may receive, but will

never be obligated to make, a

termination payment.

• Typically assignable by borrower.

Advantages and Disadvantages of Rate Caps


Disadvantages

•Rate cap requires upfront premium.

•Cost increases exponentially with

duration.

•Rate caps typically limited to three

years.

• Assumptions

– Loan interest rate: LIBOR + 1%

– LIBOR at closing: 2%

– Strike Rate on Rate Cap: 3%

– Borrower net cost capped at Strike + Margin 4%

• If LIBOR goes up, Rate Cap proceeds fund Borrower's increased interest cost.

– Example: LIBOR increases to 6%

□ Borrower pays Loan interest rate: 6% + 1% = 7%

□ Borrower receives from Rate Cap Provider: 6% - 3% = 3%

□ Borrower net borrowing cost: 7% - 3% = 4%

• If LIBOR goes down, cashflow from property funds Borrower's interest cost.

– Example: LIBOR decreases to 1%

□ Borrower pays Loan interest rate: 1% + 1% = 2%

□ Borrower receives from Rate Cap Provider: 0% (LIBOR less than Strike Rate)

□ Borrower net borrowing cost: 2%

Borrower Cost Capped Whether LIBOR Rises or Falls


• A swap is an exchange of a floating interest rate (e.g., LIBOR) for a fixed interest

rate (e.g. 2.5%). Typically no upfront payment is required.

• Fixed rate will be a “swap rate” determined by the swap provider at the time of

the trade (not selected by borrower or lender).

• Notional amount and duration are typically the same as for a rate cap.

• Fixed Rate and Floating Rate payments are netted against each other.

Interest Rate Swaps


Borrower Swap

Provider

LIBOR

Fixed Rate

Swap Cashflows

• Swap converts Borrower's floating rate obligation to a fixed rate.

• If LIBOR rises, Borrower receives cash under swap, pays higher loan interest rate.

• If LIBOR falls, Borrower pays cash under swap, pays lower loan interest rate.

• Borrower's effective financing cost: Fixed Rate plus Loan Spread.

Combining Swap and Loan


Loan

Lender Borrower Swap

Provider

LIBOR + Spread X

Combining Swap and Loan Cashflows

LIBOR X

Fixed Rate

Swap

Advantages

• No upfront payment required.

• Longer durations available.

• Fixed/swapped rate will not

change over time.

Advantages and Disadvantages of Swaps


Disadvantages

•Borrower does not benefit from decline in

floating interest rate.

•Borrower has ongoing payment obligations.

Therefore, swap provider typically requires

collateral or other creditworthiness.

•Two way termination payments are possible.

•Typically not assignable by borrower.

Creditworthiness/Collateral Issues re: Swaps

February 22, 2017

• Borrower has ongoing payment obligations under a swap.

• Swap Provider will request to be secured party.

• Identity of the swap provider:

– Lender vs. loan syndicate member vs. unrelated party

• Intercreditor issues, even where Lender and Swap Provider are same entity.

• Consider requiring Borrower to use an affiliate to enter into swap.

– Avoids giving swap provider a security interest in the property.

16

Disparate Objectives of the Parties to Rate Caps

February 22, 2017

• Lender – robust cap

• Borrower – minimize cost

• Rate Cap Provider – high-volume, low-profit transaction

• Parties' disparate objectives can and frequently do result in risks for the

Lender and Borrower.

• Many of these risks may be minimized.

17

Rate Cap Provider Downgrade

February 22, 2017

• Rate Cap Risks

– Cap Provider bankruptcy or insolvency

• Rate Cap typically includes a "downgrade" provision:

– Cap Provider credit rating must exceed a specified threshold at closing.

– If Cap Provider rating drops below a specified trigger, Cap Provider must

either post collateral or replace itself.

– If Cap Provider rating drops below a second trigger, Cap Provider must

replace itself (and must post collateral until replacement is accomplished).

– Certain Cap Providers use parent guarantor to provide the necessary rating.

18

Placing a Rate Cap


• Rate caps:

– Because rate caps do not require any collateral, borrower may purchase rate

cap from any hedge provider that meets the lender’s ratings requirements.

– Best pricing for rate cap typically achieved through an auction.

– Borrower's hedging advisor typically prepares a “bid package” and sends it to

prospective hedge providers to solicit interest for the auction.

– Often, between 2-4 financial institutions agree to participate in the auction.

– On day of trade, hedging advisor holds recorded calls with each bank to

accept their bids. The rate cap is generally awarded to the lowest bidder.

Placing a Swap


• Swaps:

– Greater challenge regarding pricing.

– Borrower has ongoing payment obligations, so swap providers typically require

collateral.

– However, lenders typically will not permit an unaffiliated hedge provider to have

a security interest in the loan collateral. Borrowers thus are generally

compelled to execute swaps with the lender.

– To ensure fair rate fixing, hedging advisor will negotiate with lender/swap

provider for a specific number of basis points over published swap rates.

– On day of trade, hedging advisor holds a recorded conference call with

lender/swap provider, to:

□ Review trading screen where agreed-upon swap rate is published,

□ Discuss the swap rate, and

□ Upon agreement, confirm that swap trade is executed.

Hedge Specific Documentation


• Hedge Term Sheet/Bid Package

• Recorded phone call during which trade is executed

• Trade Ticket

• Hedge Confirmation

• ISDA Master Agreement and Schedule to Master Agreement

Hedge Term Sheet/Bid Package


• Bid Package

– Typically prepared by hedging advisor.

– Borrower and Lender should take a firm interest in the bid package.

– Confirm that confirmation conforms to bid package.

– Defined terms in hedge should match defined terms in Loan Documents (e.g.,

floating rate, rounding, business day, payment date, strike rate, maturity date).

Recorded Phone Call to Execute Hedge


• Generally done on day of, or within a day prior to, loan closing.

• Real estate attorney typically not involved in the trade phone call.

Trade ticket


• Hedge provider generates trade ticket immediately after hedge is executed on

recorded phone line.

• Very short form document recording the primary elements of the hedge.

Hedge Confirmation


• Detailed confirmation of the executed rate cap or swap.

• Should match the term sheet/bid package.

• Hedge provider typically prepares confirmation within several days after trade

execution.

• Documents Affecting Hedge Agreement

– Loan Application

– Loan Agreement/Promissory Note

– Collateral Assignment of Hedge

– Bid Package

– Trade Ticket

– Hedge Documentation

– Dodd-Frank Protocols

Loan and Hedge Documentation


ISDA Master Agreement

Schedule

Confirmation(s)

ISDA Definitions

-- or --

"Long-form Confirmation“

Hedge Provider parent guaranty,

if needed for ratings requirement

Hedge Provider legal opinion

Selected Loan Agreement Provisions re: Hedge


• Conditions Precedent re: Hedge Agreement

– Broad outline of hedge terms, e.g., rate, term, notional amount

– Swap provider consent to collateral assignment

– Hedge reasonably satisfactory to Lender (or Agent)

• Borrower Covenants

– Maintain hedge agreement over specified term

– Replace hedge upon swap provider downgrade

– Hedge covering loan extension period

• Lender consent to modifications or termination of hedge agreement

• Borrower obligation to pay interest unaffected by hedge agreement

Selected Loan Agreement Provisions re: Hedge


• Failure to maintain hedge constitutes a borrower event of default

• An event of default under the hedge is typically a borrower event of default

• Application of hedge proceeds

– In general

– Upon hedge event of default or termination event

• Waterfall

– Borrower swap payments to lender/hedge provider

– Borrower swap payments to unaffiliated hedge provider

• “Additional Interest”

– Borrower swap obligations typically denominated as “additional interest”

– Mortgage secures borrower’s “additional interest” obligations

Loan Provisions Relating to Hedge Calculations


• Floating Rate in Loan Agreement and Hedge Should Match

• Notional Amount

– Fixed

– Stepdown

– Overhedging: Optional or Mandatory Partial Breakage

• Breakage

Regulatory Issues: Dodd–Frank

February 22, 2017

• Dodd-Frank Title VII—Regulation of Over-the-Counter Swaps Markets

• Dodd-Frank can have a significant effect on hedges, particularly where a swap,

rather than a rate cap, is used.

• Key issues:

– Eligible Contract Participant (ECP)

□ Borrower and every co-obligor and guarantor of swap cashflows must

qualify as an ECP

□ Generally, to qualify as an ECP an entity must have:

Total assets of at least $10 million, or

Net worth of at least $1 million, if swap if is in connection with its

business or hedging its assets or liabilities

– "End User" Clearing and Margin Exemptions

– Swap Reporting - obligation of the Swap Dealer

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Q&A

February 22, 2017

• Final Thoughts

• Questions & Comments

31