One of the major benefits of commercial real estate investment is that debt is widely available at generally favorable terms. One term specifically, the debt’s interest rate, is a critical component in an investment’s return calculation. But, the thing about interest rates is that they are always changing, as the market fluctuates, so do loan interest rates, which presents an interesting opportunity for the most sophisticated real estate investors. In order to understand what the opportunity is, it is first important to understand what interest rates are, how they are calculated, and why they are important in a real estate investment.
Interest Rates Explained
Simply, a loan’s interest rate is an annual percentage charged by the lender for the privilege of using their money. Depending on the type of loan, the amount of interest owed in a given month is generally calculated by dividing the annual interest rate by 12 and multiplying it by the outstanding loan balance at the end of each month. Since each loan payment is divided between principal and interest, the interest rate charged is a major factor in the loan payment calculation.
For a lender, the decision of what interest rate to charge is influenced by a number of key variables including their cost of capital, the perceived risk associated with the loan, the loan’s term, and the strength of the borrower. On its face, this decision may seem like a relatively simple one, but it is complicated by the fact that interest rates are always changing which means that there is some level of risk that the lender may not charge the most optimal rate. An example is helpful.
Suppose that a real estate investor was looking to purchase a property that they planned to hold for 10 years and their banker approves them for a loan with a 10 year term and a fixed interest rate of 5.00%. But, by year 3 of the loan, prevailing interest rates at that time have risen to 6%, which means that the lender is now losing out on earning that extra point of interest and they will continue to do so as long as market rates remain above the rate they charged the investor. In this scenario, the rate change went against the lender, but it could also go against the borrower. Suppose the same situation, but instead of rising to 6%, interest rates fall to 4% and the borrower is stuck paying an above market rate. In this case, the borrower would be incentivized to refinance their loan at the lower rate, but this comes with high transaction costs.
But, not all loans are fixed rate loans. Some loans are floating rate loans, which means that the interest rate changes over the loan’s term. In such cases, the actual rate of interest is typically calculated using an interest rate benchmark like LIBOR (London Interbank Offered Rate) or Prime and adding a certain percentage to it. For example, a loan could have an interest rate of LIBOR + 1%, which means that the loan’s rate will change as the value of the underlying index changes. Generally, loans with a floating interest rate are considered to have more risk than a fixed rate loan because large changes in the rate can result in equally large – and unexpected – changes in a loan’s payment. Again, this works both ways.
Using the same example above, suppose the loan had a floating interest rate of LIBOR + 1%, which was equal to 5% at the time of loan closing. If the rate rises to 6% by year three, this works in the lender’s favor because they are now earning more interest and it works against the borrower because their payment is now larger. But, the situation could also work the same in reverse. If the rate falls to 4%, the borrower benefits because their payment goes down and the lender suffers because they are now earning less interest.
To protect against unexpected changes in an interest rate, both the lender and the borrower have the option to enter into a sophisticated derivative contract known as an “interest rate swap.”
What is an Interest Rate Swap?
An interest rate swap is a contract between two parties, known as counterparties, who agree to take opposite sides of a bet on the direction of interest rates. In other words, they agree to swap streams of cash flow related to the interest rate charged. There are many different types of interest rate swap contracts, but in real estate the most common is a “fixed for floating” exchange. In such an exchange, a borrower would agree to a fixed rate loan with a lender and then enter into a swap contract where they agree to make a fixed stream of interest payments in return for receiving a floating rate stream of payments. To illustrate this point, consider the following example.
Suppose the investor above enters into a loan contract with a lender at a fixed interest rate of 5%. But, after doing a significant amount of research, they are confident that interest rates are going to rise over time. To take advantage of this, they enter into an interest rate swap agreement where they find a counterparty who agrees to accept their stream of fixed rate payments in exchange for a stream of floating rate payments based on an index of LIBOR + 1%. If the investor is right, and rates rise, they will benefit because they end receiving more money than they are required to pay. But, if they are wrong and rates fall, they could end up paying even more interest than they receive, a net negative. For this reason, there are two primary risks that must be considered before entering into a swap agreement.
Interest Rate Swap Risks
For both parties to the swap, there are two risks that must be considered, interest rate risk and credit risk.
Interest rate risk is fairly self-explanatory one. It is the risk that interest rates do not move in the expected direction causing one party to pay more than would have been required if they did nothing. Interest rates themselves generally do not make huge moves in a short period of time, but interest rates swaps are typically associated with loans that have a large principal amount, which means that even the smallest unexpected change could result in a large dollar consequence.
Credit risk is a little bit more tricky. Implied in the interest rate swap agreement is the idea that each party has the ability to meet their obligations as outlined in the agreement. If one side is unable to do so, the other side does not get to reap the benefits of the swap. To understand how this works, an example is helpful.
Interest Rate Swap – An Example
It is not the intent of this article to get into the pricing formulas used to calculate the value of the swap as they can be very complicated. Instead, an example of a plain “vanilla swap” is used to demonstrate how the transaction works in practice.
Suppose that Counterparty “A” is a multifamily investor who has recently taken out a floating rate loan with a principal balance of $1,000,000 (e.g. the “notional amount”). After some research, they have come to the conclusion that interest rates are going to rise in the future and they want to protect themselves from rising payments on their loan. So, they enter into an interest rate swap agreement with counterparty B (who thinks that interest rates are going down) whereby they agree to make a fixed stream of interest payments at a rate of 6% in exchange for receiving floating rate payments based on the rate index of LIBOR + 1%. The agreement has a maturity date in two years with quarterly interest payments.
At the start of the contract, both “legs” of the agreement are valued the same because LIBOR + 1% is equal to 6%. At the end of the first quarter, it turns out that Counterparty A was right and the variable interest rate of LIBOR + 1% (100 basis points) has risen to 7%. So, at the end of the first quarter, it is time for them to settle up.
Counterparty A owes Counterparty B one quarter’s worth of interest payments on $1,000,000 USD at 6% or $15,000 (($1,000,000 * 6%)/4). Counterparty B owes Counterparty A one quarter’s worth of interest payments on $1,000,000 at 7% or $17,500. (($1,000,000*7%)/4). To make it easy, the difference is netted and Counterparty B must pay Counterparty A $2,500. This example also demonstrates the concept of Credit Risk, which is the risk that Counterparty B cannot afford to make the required payment.
The bottom line is this, interest rate swaps can be an effective hedging tool for real estate borrowers and investors to protect themselves from the risk of changing interest rates. However, these derivative contracts can be complicated, risky, and expensive. They are only recommended for the most sophisticated investors who have prior experience dealing with them. Otherwise, they have the potential to result in adverse outcomes.
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