Europe real estate market update—6 April 2020

Market data provided in this post was accurate as of close-of-business on Friday, 3 April, 2020, but may quickly become dated given current market conditions. Data seen here should not be used for any analysis or transactions.

If you tuned in to our market update last week, we introduced the possibility for commercial real estate borrowers to restructure their interest rate swaps to reduce or eliminate payments in the near term in exchange for higher payments later. Since then, we’ve had a number of conversations with CRE investors on this topic. This includes situations in which the investor was in the process of an actual forbearance discussion with their lender on a swapped loan, and also situations in which the investor was not yet in formal restructuring discussions but wanted to reduce current interest expense in conjunction with declining asset net operating income (NOI).

For the borrowers who are not facing immediate liquidity constraints, the current interest rate environment still presents a compelling opportunity to restructure swaps to a lower coupon and longer duration. This is especially impactful for REITs in the EPRA index and unsecured borrowers who can opportunistically hedge future debt issuance.

Given the number of conversations we’ve been having on both topics, and the expectation that these types of swap restructures are likely to become more common in the coming weeks, we thought we’d use our post this week to explore them in more detail.

Alternative 1: Temporarily reduce or defer loan payments and preserve cash

Overview

Many CRE borrowers achieve fixed-rate financing profiles on their loans via interest rate swaps. The borrower closes a floating-rate loan with a bank lender and simultaneously enters into a fixed-rate swap with that lender’s swaps desk, achieving a synthetically fixed rate. Because interest rate swaps are highly customizable and negotiable, they lend themselves to restructuring. This flexibility enables a cash-constrained borrower to potentially amend a swap to temporarily reduce or defer payments and preserve cash in periods of NOI decline.

This is achieved by restructuring the swap to reduce or eliminate their swap coupon today in exchange for a higher coupon in the future, effectively amending the swap rate to “step up”. This may be accomplished independent of a loan forbearance, allowing a borrower to temporarily reduce debt without having to engage in formal workout conversations with the lender. This can also be done in conjunction with a loan forbearance that will temporarily eliminate all debt service. While an opportunity like this may seem attractive when viewed through the lens of an immediate reduction in interest expense, such a restructure involves a number of risks and considerations.

Risks and considerations

Eligibility: Reducing a borrower’s current swap rate in exchange for a higher rate later increases the swap’s credit exposure. This may necessitate additional credit approval by the swap provider/lender and may not be available to all borrowers.

Relationship to loan forbearance: A swap restructure needs to be considered in the context of any broader loan forbearance. By itself, a swap restructure provides an opportunity for a borrower to lower (but not eliminate) their interest expense without approaching a lender to restructure the loan itself. It can provide interest expense relief without the time, fees, and stigma of a loan workout. If forbearance is being considered (to temporarily eliminate debt service), it is important to keep in mind that a forbearance of interest under the loan may not automatically result in swap payments being deferred or reduced.

Increased costs: A borrower will incur trading and credit costs which will be embedded in the restructured rate. While the restructured swap may conserve current cash, it may also be net present value (NPV) and cashflow negative on a net basis over the life of the swap.

Increased swap prepayment/breakage costs: Although exempt from interest payments on the front end, borrowers that defer payments will have larger swap liabilities once the swap rate steps up, magnifying potential future swap prepayment costs. A borrower that is considering a swap amendment to defer payments therefore needs to weigh the immediate cash relief against the risk of a higher swap breakage penalty in the event that the asset is sold or refinanced prior to the loan maturity.

Accounting: Accounting sensitive GAAP filers may need to consider the accounting implications of a restructured swap.

Adequacy of relief and timing: Borrowers should evaluate the length of time they need a payment deferral for, and whether that payment deferral is adequate to relieve immediate cash constraints against how they’ll manage the higher payments once the swap rate steps up.

Examples

To better illustrate how a swap restructure might work in practice, below are two examples of a swap restructuring—one in which the swap is restructured without a loan forbearance and one in which a swap is restructured in conjunction with a loan forbearance. Each example looks at the same underlying loan—a £100 million loan maturing on 1 April 2025 priced at 3-month LIBOR + 2.00% for which LIBOR was swapped to fixed at a rate of 1.50%, resulting in an all-in loan coupon of 3.50%.

Example #1: Swap restructure without loan forbearance

In this example, the borrower reduces the base swap rate from 1.50% to 0.00% for six months (1/4/—1/10/2020) in exchange for a higher swap rate of 1.67% for the remaining term. The borrower reduces their interest rate by 1.50% for six months without any new loan documentation, legal fees, or other restructuring/forbearance notice or proceedings.

Example #2: Swap restructure with loan forbearance

In this example, the borrower pauses all swap payments for six months (1/4/2020—1/10/2020) in conjunction with deferral on the underlying loan payments. This eliminates interest expense for six months in exchange for a higher swapped rate for the remaining term and an additional balloon payment at loan maturity to repay the deferred interest on the loan. In this example, we assume no interest accrues on this balloon payment—it is essentially an interest free loan. This approach is consistent with some loan/swap restructures to which Chatham has observed this week but not reflect how all lenders may treat a loan workout.

Alternative 2: Exchange upfront swap breakage costs or a longer swap maturity for a lower interest rate

Overview

Borrowers who are not facing liquidity constraints have additional options to reduce swap interest costs by either (1) terminating existing swaps, paying the swap liability, and entering into a new swap at lower market rates, or (2) blending the existing swap liability into a new swap with a longer maturity and lower interest rate.

Risks and considerations

Eligibility: Terminating and re-couponing a swap does not change the lender’s credit position and should be a straightforward process. Blending the existing swap liability into a new swap with a longer maturity will necessitate additional bank approval whether carried out in connection with the refinance of an existing loan or on an unsecured basis for the borrowers eligible to do so.

Increased costs: A borrower will incur trading and credit costs which will be embedded in the restructured swap rate. While the restructured swap may reduce interest expense, it may also be NPV and cashflow negative on a net basis over the life of the swap.

Swap prepayment/breakage costs: Terminating and re-couponing a swap begins by paying the existing swap liability to the bank, making this strategy suitable only for borrowers who are not facing immediate liquidity constraints. Blending and extending the existing swap liability into a new swap does not impact the swap liability (aside from additional credit charges applied by the bank). This strategy will lengthen the swap duration which does make it more susceptible to daily fluctuations in interest rates.

Examples

Example #3: Re-coupon swap to improve EPRA earnings

In this example, a borrower with a £100 million loan maturing 1 April 2025 priced at LIBOR + 2.00% and swapped to fixed at 3.50% pays the swap breakage premium of £5.4 million and re-coupons the swap rate at 0.42% bringing the all-in coupon down to 2.42% for the remaining term. For REITs in the EPRA index, the cash outflow is recorded as a one-time hit to NAV, but the lower interest expense benefits future earnings.

Example #4: Swap blend and extend to reduce interest expense

A borrower with a £100 million swap fixed at 1.35% with three years remaining extends the swap maturity to five years bringing the swap rate down to 1.00%. This is achieved by embedding the existing swap liability into the current 5-year swap rate, which is meaningfully lower than the current swap rate. While the new swap rate is still “above market”, quarterly interest expense is reduced, and the swap duration is extended.

Wrap-up and next steps

A swap restructuring may allow you to quickly reduce your interest expense on a loan without the full negotiation and documentation exercise of a loan restructuring. In the context of loan forbearance, a swap restructure will be a necessary step to fully defer interest expense. In either case, CRE investors will need to benchmark the economics of the restructuring in order to understand the costs they are incurring in doing so, and whether those costs are market.

Please feel free to reach out to your Chatham representative if you'd like to further evaluate the availability and suitability of such a transaction.