Your interest rate hedge may be worth more than what you paid for it
Hedging and Capital Markets
Real Estate | Kennett Square, PA
You may not have noticed, but your interest rate hedge may be worth quite a bit of money. As the Fed turns more hawkish in the face of inflation (which seems to be more than transitory), the forward curve for short-term rates has steepened significantly. The market is pricing in as many as seven rate hikes this year and two more next year and the Fed is projecting a longer-term terminal rate of ~2.5% for short-term rates (as expressed in the Fed Dot Plot). With this new set of expectations, the forward curves for base rates on floating rate loans like SOFR have steepened significantly, as the graph below shows.
As the market has priced in a greater likelihood that SOFR will rise more quickly, interest rate hedges (including interest rate caps and interest rate swaps) that protect borrowers against increases in SOFR have increased in value. The table below illustrates how interest rate cap costs have increased over the past 12 months, driving many borrowers to engage with lenders to find creative ways to reduce cap costs, including:
- Reducing the required term
- Using “step-up” structures where the strike rate of the cap increases over time in line with underwritten net operating income (NOI)
- Using “springing” caps which don’t need to be purchased at closing but rather only if/when rates hit a certain threshold
If there is a silver lining to these market conditions, it is with legacy hedges that borrowers have already booked. Borrowers who have purchased caps are seeing the value of their caps increase. Borrowers with interest rate swaps are seeing that “prepayment” costs associated with terminating those swaps early are declining, or, in some cases, becoming positive. In the past few weeks, we’ve worked with our clients who have redeemed/refinanced loans to monetize the residual value of an existing hedge. As an example, last year we helped a client purchase a three-year cap on a $425M LIBOR loan with a strike of 1.43% for a premium of $805K. This past month, they refinanced the loan and no longer needed the cap. We were able to help them sell their cap back to the market for $1.8M, more than twice what they paid for it.
With this in mind, we encourage clients to review their portfolios of financings and hedges. Consider the following:
- Review interest rate caps on repaid loans. If you have an interest rate cap associated with a loan that has been repaid, we can quickly tell you its current value and assess whether you can recoup any of it, whether through terminating it with the existing cap provider or possibly selling it to another. Keep in mind that lender-required caps likely can’t be sold in this way if the loan itself is not being redeemed.
- Review elective interest rate caps. If you have a cap that you purchased electively without a lender requirement, or if you purchased more protection (lower strike or longer term) than the mandatory minimum, you should get in touch with us. While we’d argue that this is exactly the market environment in which you’d want to keep the cap in place, it is helpful to understand what that position would be worth if you monetized it today.
- Review loans with swaps. If you are repaying a loan which is hedged with a swap, the swap might be an asset to you. We can ensure that you receive the appropriate value when the loan is paid off and the swap terminated. Even if a swapped loan is not being paid off, you still might be able to “re-coupon” the swap today, which would involve increasing the swap rate (increasing the all-in loan coupon) in exchange for a lump sum cash payment. The latter isn’t done frequently; it typically requires a lender credit review. We think it’s an idea worth exploring in situations where the underlying asset is covering debt service well and the cash payment might benefit return hurdles.
- Revisit prepayment estimates. With the increase in short-term rates, prepayment penalties on fixed-rate debt are trending down, which may bring additional refinance opportunities. Our prepayment team is happy to review fixed-rate loans and provide estimates on prepayment costs.
Do you have questions about the value of your cap or swap?
Contact an expert
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.22-0034
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