The Use of Interest Rate Caps and Swaps by NTRs in a Rising Rate Environment
June 21, 2022 | James Sprow | Blue Vault
A recent Special Report published by Marcus & Millichap goes into great detail on the use of interest rate caps and swap contracts by commercial real estate investors to hedge their debt liabilities against rises in interest rates. With the Federal Reserve’s commitment to raising interest rates to battle inflation, these hedging tools have become more prominent in the minds of financial managers at nontraded REITs and their sponsors. Because many nontraded REITs have variable rate debt with their interest rates tied to indices such as LIBOR or SOFR, the recent rises in interest rates can impact the cost of hedging instruments and result in lowering the bottom lines of REITs utilizing them.
Blue Vault reports quarterly data for all active nontraded REITs (NTRs) including the percentage of the REIT’s debt that is at variable rates. We consider any variable rate debt that has an effective interest rate below the caps that may be in place to be variable rate debt rather than fixed rate debt. To be considered fixed rate debt, the variable rate must have risen to exceed the interest rate cap, meaning the cap is “binding” and effectively limiting the interest rate to the cap rate. Given the recent steep rise in interest rates and the interest rate indices that are used to determine the rates on variable rate debt, more of the caps that NTRs have in place will become “binding” and change Blue Vault’s classification of the debt to fixed rate.
REITs also use interest rate swaps. Those contracts allow a borrower to choose to take a floating rate, generally more pre-payable loan, and make it a fixed rate loan for a certain term, typically five to 10 years. Banks are the counterparty to swap contracts, and they will increase the swap rate they offer above the fair value swap rate to account for credit risk and to add a profit margin. REITs may finance stabilized properties with fixed rate loans but utilize a swap for a bridge loan or construction financing, like a line of credit.
A swap contract has a two-way risk to the borrower, called a “breakage.” This comes into play when the borrower does not ride out the full term of the swap and prepays the loan prior to maturity. When rates are rising, the swap can be an asset to the borrower when they prepay, but in a falling interest rate environment the swap can be a liability, resulting in a large prepay penalty to the borrower.
The cost of a swap contract made today depends upon how the market anticipates future interest rates. These projections are called the “forward curve.” The historical data shows that in times of rapidly increasing interest rates, the forward curve has generally underestimated the actual rate increases. Even though history indicates a swap in a rising interest rate environment may be an asset, it is also true that the counterparty to the swap will charge a higher price by setting a higher swap rate. For example, as of June 14, 2022, a five-year term loan with an interest rate of 225 bps over the one-month SOFR rate would translate to an all-in swapped rate of around 6.00 percent, whereas the all-in floating rate as of that date was 3.58%.
Nontraded REIT Exposure to Unhedged Variable Rate Debt
As of March 31, 2022, all active nontraded REITs had approximately $54.7 billion in variable rate debt on their balance sheets, which by Blue Vault’s definition is debt that is not fixed by swap contracts or debt on which interest rate caps were not binding at that date. This total made up 57.6% of the debt outstanding for all active NTRs of approximately $95.1 billion.
The largest nontraded REIT by far by total assets, Blackstone Real Estate Income Trust, had total mortgage notes, term loans and secured revolving credit facilities, net, of $41.4 billion, as well as secured financings of investments in real estate debt of another $4.6 billion. The REIT’s variable rate loans totaled $22.3 billion. The variable interest rates on the REIT’s debt varied from LIBOR + 1.6% to LIBOR + 3.5%, with a weighted average floating rate of L + 1.9%. As of March 31, 2022, the REIT had swaps outstanding with an aggregate notional balance of $16.6 billion to mitigate exposure to potential interest rate increases for their floating rate debt. For the three months ended March 31, 2022, a 10 bps increase in each of the reference rates would have increase the REIT’s interest expense by $11.8 million, net of the impact of their interest rate swaps. (The REIT’s Net Income for Q1 2022 was $96.6 million.) These figures give an illustration of the potential importance of rising interest rates on the profitability of a nontraded REIT.
The one-month LIBOR rate as of June 13, 2022, was 1.324%, up from 1.062% as of May 27, 2022. This 26 bps increase would have a substantial impact on BREIT’s net income for the second quarter of 2022 if unhedged via swaps.
Conclusions
Looking at the increase in unhedged variable rate debt utilized by the active nontraded REITs in Blue Vault’s coverage, from 39.6% in Q1 2021 to 57.6% of outstanding debt in Q1 2022, we can expect the impact on REIT net income to be substantial. REITs will also have to consider the increased costs of hedging variable rate debt in the current interest rate environment. It would be expected that REITs would be taking advantage of the historically low borrowing rates that have been available over the past several years, but the days of low rates may be over. Even though today’s rates are still low by historical standards, the cost of swaps and cap contracts will depend upon expectations for interest rates as reflected in forward curves, and currently those forward curves are definitely upward sloping.
Definitions:
SOFR: The Secured Overnight Financing Rate is a broad measure of the cost of borrowing cash overnight, collateralized by Treasury securities. The SOFR is calculated as a volume-weighted median of transaction level data from the Bank of New York Mellon and the U.S. Department of the Treasury’s Office of Financial Research. A SOFR value is published each business day and is now being used as a replacement benchmark for the sunsetting LIBOR metric.
Interest Rate Cap: The borrower can set a limit, or strike price, on how high the floating rate goes in their loan by making an up-front payment. The lower the cap (strike) and the longer the term, the greater the up-front cost. The interest rate cap can never be a liability to the purchaser of an interest rate cap, so the total possible cost is the premium paid at the onset. During the term of the cap, the borrower still pays the floating rate as long as it is below the strike.
Interest Rate Swap: Ability for a borrower to exchange a loan with a floating interest rate for a fixed rate profile for a certain length of time. The fixed rate is based on the current forward curve for the benchmark interest rate. A common benchmark rate used today is SOFR.
Forward curve: A forward curve is the present-day expectation of how a measure will perform in the future. As such, forward curves are dynamic and can shift greatly as perceptions of the future change. Forward curves for benchmark interest rates, such as SOFR, are used for a variety of purposes, including in determining the contractual rate in an interest rate swap and a factor in the price of interest rate caps.
Sources: SEC, Marcus & Millichap Special Report June 2022 “Capital Markets: To Swap or Not to Swap” Blue Vault
