How REITs Hedge Variable Rate Debt
June 15, 2023 | James Sprow | Blue Vault
With the rise in interest rates since March 2022 when the Federal Reserve first began implementing rate hikes, nontraded REITs have faced challenges to protect their variable rate borrowings from drastic increases in interest rates. For example, when the Federal Reserve began raising interest rates, one of the most important indices that variable rate borrowing rates to which those contracts are linked, for example the 6-month LIBOR, has increased from close to zero in January 2022 to 5.7% in June 2023.
Where re-financing variable rate with new fixed rate debt is impractical or expensive, REITs can utilize two hedging techniques to effectively accomplish the fixing of interest rate on their debt obligations.
Interest Rate Caps
One method of hedging interest rate risk is to purchase an interest rate cap contract. Caps are agreements with a counter-party, often a bank, whereby the variable interest rate on a debt is fixed once it reaches an agreed-upon level, called the “strike.” With a cap contract, the borrower negotiates with the counter-party to compensate the borrower for any additional interest expense to be incurred when the contractual variable rate of interest exceeds the striking rate. It is effectively an insurance policy the borrower can purchase for a specified period of time to protect against interest rate increases. The interest rate cap agreement is based on a floating interest rate index, such as 1- or 6- month LIBOR (or SOFR), and the notional amount of the agreement is equal to or less than the loan amount. The interest rate cap agreement may have a term that matches the maturity date of the loan and may allow the notional amount to be reduced in case of prepayment of the loan.
Interest Rate Swaps
A second method of hedging interest rate risk is an interest rate swap. An interest rate swap is a forward contract in which one stream of future interest payments is exchanged for another based on a specified principal amount. In the current environment of rising rates, interest rate swaps usually involve the exchange of a variable interest rate for a fixed rate, to reduce exposure to fluctuations in interest rates. In the case of REITs, a nontraded REIT may hedge their variable rate debt by negotiating a swap contract with a counterparty, such as a bank, whereby the counter-party agrees, for a fee, to pay the REIT’s variable interest expense related to its variable rate debt and charge the REIT a fixed rate of interest. For accepting the risk of changes in interest rates and the variable cash flows that those changes cause, the counter-party will be compensated by the REIT with a negotiated fee.
Interestingly, counter-parties such as banks can arrange their swap contract portfolios to be interest rate neutral if the notional values of fixed-for-variable and variable-for-fixed contracts are roughly equal.
The Change from LIBOR to SOFR
Variable rate contracts are usually tied to a particular interest rate index. For many years the most common index used was LIBOR, or the London Interbank Offered Rate. Although LIBOR has been used since the 1980s, regulatory reforms have begun in recent years to reform benchmark rates and ultimately replace LIBOR as the interbank borrowing rate. In 2022, Congress passed legislation to make SOFR the official replacement for LIBOR in the U.S. The Secured Overnight Financing Rate (SOFR) becomes the reference rate as of June 30, 2023. Banks were instructed to stop writing contracts using LIBOR by the end of 2021. A record 91% of new dollar swaps executed in May used the SOFR as their reference rate.
Has the Nontraded REIT Industry Moved Away from Unhedged Variable Rate Debt?
Any analysis of the use of variable rate debt, fixed rate debt, and derivative instruments such as caps and swaps by the nontraded REIT industry must take into account the importance of the largest REITs in terms of total assets and total debt. Blackstone REIT alone made up 58.7% of the NTR industry’s total assets and 62.9% of the industry’s total debt outstanding at year-end 2022. Starwood REIT’s assets were 11.0% of the industry’s total assets as of December 31, 2022, and the REIT had 10.9% of the industry’s total debt outstanding. Blackstone REIT stated in their annual report for 2022 that 91% of their total debt was effectively hedged via caps and swaps contracts, making it fixed rate debt. Starwood REIT stated that fully 98% of their debt was effectively hedged at year-end 2022.
Looking back, as of March 31, 2021, Blackstone REIT had only swap hedges with a total notional value of just $2.55 billion and strikes of 1.1%. These were the only hedging contracts listed. These hedges and their notional value represented just 13% of the REIT’s mortgage, term loan and revolving debt total of $19.64 billion. Clearly, between Q1 2021 and Q4 2022, the REIT has taken action to hedge a much greater portion of their interest rate risk.
As of March 31, 2021, Starwood REIT had interest rate swap and cap agreements in place with fair values of $0.8 million and $1.7 million below their respective costs. The REIT does not report the percentage of their variable rate debt that had been effectively fixed via these derivatives, but with $3.34 billion in mortgage notes and a revolving credit facility as of that date and $1.06 billion of that at variable rates, the hedges do not appear to be binding. For example, $887 million of the REIT’s mortgage debt was at a weighted average interest rate of L + 1.81% (L = one-month LIBOR). The one-month LIBOR index at March 31, 2021 was less than 0.1%, meaning the derivative contracts were most likely not yet effective as interest rate hedges.
Conclusion
Two means of hedging interest rate risk related to variable rate borrowing are caps and swaps, derivative contracts negotiated with counter-parties to convert variable interest rates to fixed rates. Two of the largest nontraded REITs have greatly increased their hedging activities during the period of interest rate increases since March 2021.
Sources: SEC, REIT websites, global-rates.com, statista
