Interest rate swap FAQs for CRE investors
These frequently asked questions address some of the common issues that commercial real estate borrowers face when considering an interest rate swap. These include swap rates and mechanics, prepayment/breakage, and documentation.
For a general overview of interest rate swaps and how they work, please read: What is an interest rate swap?
- Where can I find swap rates?
- What should I consider in my term sheet to ensure I get the optimal outcome in my swap execution?
- On what types of loans is a swap available?
- Why am I limited to my lender for an SPE-level swap on mortgage debt?
- Is there a difference between basis points in credit charge versus basis points in loan spread if they get you to the same all-in coupon?
- What happens if I have an interest rate floor in my loan? Will it affect my swap?
- If I cannot auction my swap, how does Chatham help with pricing on a direct swap with my lender?
- What should a CRE borrower consider when evaluating a swap?
- How do swaps compare with interest rate caps?
- How are my loan and swap related?
- What is swap breakage? How do I calculate swap breakage?
- What happens if I sell/refinance my deal when I have a swap?
- My loan term is seven years, but I think I might sell my property in three years. Should I enter into a seven-year swap?
- Why is my swap such a large liability?
- How can I get out of this large swap liability?
- What is a "blend and extend"?
- Can swap breakage be more punitive than a prepayment penalty on a fixed-rate loan?
- What is the ISDA and why is it important? Is it negotiable?
- What are the most commonly negotiated ISDA provisions?
- What counterparty protections do I have?
- Can I transfer/assign my swap to a different entity/asset if I pay off the loan early?
Swap rates and mechanics
Where can I find swap rates?
Mid-market swap rates can be found on Chatham’s website, and are updated multiple times daily. These should be used for indicative purposes only, not for executing transactions. Swap rates can change materially over the course of day. Please reach out to your Chatham consultant for live swap rates.
In the U.S., it is important to draw a distinction between swap rates on floating-rate loans and swap rates used to price fixed-rate loans. For example, the 1-month Term SOFR swap rate will be relevant when a 1-month Term SOFR loan is being synthetically fixed via a swap, while the SOFR ICE swap rate will be used when pricing a pure fixed-rate loan, like CMBS. In Europe, such distinction is not present in most cases and the same swap rate is often used in floating-rate loans and referenced in fixed-rate loans.
A bank will quote a different swap rate than what you see on our website or a Bloomberg terminal. A swap rate is composed of the mid-market swap rate and a credit charge. The rate that a bank quotes may include this credit charge, and sometimes even the loan spread, representing the rate as an “all-in” coupon. Knowing where mid-market swap rates are when a bank presents you with a quote enables you to better understand the composition of the rate and the spread being charged by the bank. (Back to top)
What should I consider in my term sheet to ensure I get the optimal outcome in my swap execution?
Before signing a term sheet, it is critical to confirm and negotiate the credit charge that the bank is proposing. Many banks will not break down the components of the swap rate in the term sheet. Often, borrowers don’t know to discuss the credit charge at this stage and end up negotiating this fee after they’ve signed a term sheet. This results in less negotiating leverage to secure an improved rate. Borrowers may choose a lender based on a difference in margin of a few basis points, and then give back each basis point (and more) in a swap credit charge they neglected to negotiate upfront. Chatham can advise you during this early term sheet stage and opine on whether the credit charge is in-line with the market.
Another important consideration is whether the bank is applying an interest rate floor on the loan. This prevents the variable interest rate on the loan from falling below a certain threshold, even if the floating rate index (e.g., SOFR, SONIA, EURIBOR) falls. Most loans have floors of at least 0% on the floating-rate index, which can currently be greater than 0%. Early identification of the existence of this floor allows consideration of how it will need to be accommodated within any swap. If a swap is not structured with the floor in mind, the borrower creates the risk of their interest expense increasing if the floating-rate index falls below the floor rate. Borrowers should look out for floors in term sheets, and consider negotiating them lower or out entirely, particularly if they are greater than 0%. More details here.
To ensure flexibility in a hedging strategy, language in the term sheet which allows the choice of hedging alternatives is recommended. (Back to top)
On what types of loans is a swap available?
The availability of swaps on mortgage debt is typically governed by the lending bank and whether they have hedging capability to offer a swap to a borrower. On a typical single purpose entity (SPE)-level term loan, the swap is secured by the underlying asset, often on a pari passu basis to the loan. Consequently, a borrower will need to enter the swap with their lender. Large balance sheet bank lenders have swaps capabilities, as well as an ever-growing list of smaller regional banks. Swaps are less prevalent on debt fund, life insurance company (Life Co), and Agency (Freddie and Fannie) loans. These lenders don’t have swaps desks and/or won’t offer terms which allow a third-party swap provider to secure the swap.
The type of loan is also a factor when considering a swap. Borrowers should be cautious when contemplating a swap on a construction/development loan given the uncertainty of the timing and amount of loan draws. Swap notional profiles must be fixed at inception so if the loan is drawn more slowly than anticipated, the borrower risks paying swap interest on debt that has not yet been drawn. There are ways to mitigate this risk like only hedging a proportion of the forecast drawdowns and potentially combining the swap with an interest rate cap to provide flexibility.
Syndicated loans have their own considerations for swaps. The lending group may involve multiple banks capable of providing swaps, sometimes on just their portion of the loan, but sometimes up to the full loan amount. The borrower may let the lead lending bank “syndicate” out the swap, which may result in sub-optimal pricing, or the borrower may execute the swap with the bank (or combination of banks) which offers the most competitive pricing. (Back to top)
Why am I limited to my lender for an SPE-level swap on mortgage debt?
As swaps involve an exchange of payments between both parties over time, these future obligations create credit risk for both parties. In practice, entering a swap is contingent upon finding a bank willing to underwrite the credit. A borrower is usually required to provide collateral to secure the swap. This is most common when a borrower is an SPE created to hold an asset and associated mortgage debt. Here, the underlying asset will secure the swap by, pari passu to the loan, therefore limiting the borrower to swapping with their lender. This is a key distinction for swaps relative to caps — swaps on mortgage debt must almost always be executed with a lender on the underlying loan.
The exceptions to this are borrowers that can borrow on an unsecured basis. These borrowers, often REITs or open-ended funds, may have multiple lenders that can offer swaps without needing a security interest in the underlying asset. These borrowers may be able to approach a pool of potential counterparties and auction the swap between them, allowing someone other than the lender to provide the swap. (Back to top)
Is there a difference between basis points in credit charge versus basis points in loan spread if they get you to the same all-in coupon?
Yes. While it may be easy to think “basis points are basis points,” basis points in the swap credit charge have much more of an economic impact than basis points in the loan spread in the event of prepayment/termination. The credit charge is a component of the swap rate, which impacts the prepayment expense of the deal. Swap prepayment is calculated by comparing the contract swap rate to the prevailing market swap rate for the remaining swap term. A higher credit charge in the swap rate increases your prepayment cost. The loan spread is not included in the swap rate. Assuming that the loan does not have a spread or yield maintenance provision applicable at the time of prepayment, it does not impact the prepayment profile of the combined loan and swap. As such, it is preferable to shift bank profit from the credit charge to the loan spread to the extent feasible (i.e., accept a higher loan margin for a reduced swap credit spread). (Back to top)
What happens if I have an interest rate floor in my loan? Will it affect my swap?
Swaps should be structured to factor in the underlying loan terms, particularly any interest rate floors on SOFR or other index rates. If a loan has a floor on the index rate, borrowers must decide whether to mirror the loan floor by embedding a floor in the swap. Borrowers can embed a floor in their swap in exchange for paying an incremental premium on top of their swap rate. This ensures a fixed rate on the loan even if the variable rate index falls below the index floor rate. Alternatively, the borrower may structure the swap without the loan floor but will be exposed to higher interest costs if the index variable rate falls below the index floor. For example, if a loan has a 0% SOFR floor, but the related swap does not mirror that floor, if SOFR falls to -0.10%, the borrower will see their interest expense increase by 10 bps (basis points).
In some cases, a borrower may be able to negotiate the floor out of their loan or have the floor waived for any swapped portion of the loan. More often, the borrower must decide between paying a premium in the swap rate to match the loan floor or bear the risk of higher interest expense if rates fall below their loan floor.
Borrowers that have high index floors in their loans should also consider purchasing an interest rate cap in lieu of executing a swap. A cap purchased at the loan floor effectively fixes the coupon of the debt in the same way a swap does on a loan without a floor, but doesn't have the same prepayment risk as a swap. (Back to top)
If I cannot auction my swap, how does Chatham help with pricing on a direct swap with my lender?
Economic and legal terms of swaps can impact investment returns and risks. An advisor will assist a borrower in identifying and negotiating a bank’s credit charge and assist with the execution of the swap at loan closing. Your advisor brings pricing transparency to the transaction when competition cannot provide an incentive for a lender to be transparent. This routinely saves several basis points or more in the overall loan coupon.
An advisor also brings risk analyses, exposure evaluation, and structuring expertise, ensuring the swap is aligned with the underlying loan terms and asset objectives. Your advisor can weigh the costs and benefits of embedding a loan’s index floor into the swap as well as analyzing prepayment risk and potential mitigants. And, your advisor can quantify these exposures leading to a thorough evaluation of hedge structuring strategies.
Finally, the ISDA documents which are used in conjunction with swaps should be reviewed and negotiated to avoid introducing recourse to an otherwise “non-recourse” loan or “backdoor” events of default into the loan. A knowledgeable advisor will be familiar with these documents, negotiate them on behalf of the borrower, and ensure the borrower understands the business implications of the terms to which they agree.
What should a CRE borrower consider when evaluating a swap?
Considerations for evaluating a swap include:
- Availability: Because swaps involve an exchange of payments between the borrower and swap provider over time, these future obligations create credit risk for both parties which limit swap availability to borrowers. In most cases, a borrower entity needs to provide some sort of collateral to secure the swap. This is most common when a borrower is an SPE created to hold an asset and the associated mortgage debt. In these cases, the borrower will need to secure the swap with the underlying asset, pari passu to the loan. In practice, this will limit the borrower to swapping with the lender.
- Pricing: Two components — the mid-market rate and the transaction-specific credit charge added to it — make up a swap rate. Borrowers should be aware that the mid-market rate can move significantly between signing a term sheet and the closing of a loan, and, with their advisor, borrowers should identify and negotiate the credit charge before signing a term sheet.
- Legal provisions: A swap transaction will be documented with an ISDA Master and Schedule, industry-standard documentation for interest rate derivatives like swaps. While these documents may be presented to a borrower by a swap provider as boilerplate (or rarely negotiated), both documents should be understood and negotiated. Key provisions include language around termination events that can create cash events prior to loan maturity, language which can allow defaults on unrelated financings to trigger defaults on the swap, and language which can tie non-recourse carve-out loan guarantors to swap obligations.
- Mark-to-market: Over a swap’s life, it may fluctuate between being an asset or a liability to a borrower. This is based on the contracted swap rate relative to the market replacement rate at any given time for the remaining swap term. Swaps will always be liabilities to borrowers on day one equal to the present value of the credit charge and can fluctuate thereafter. Depending on accounting approaches, quarter-over-quarter changes in mark-to-market value may flow through earnings if the swap does not receive appropriate accounting treatment. Investment platforms that use historical cost accounting may find that changes in swap mark-to-market can impact fund returns.
- Prepayment: Although swaps do not have upfront cash costs, they may require a breakage payment if terminated early in conjunction with an asset sale or loan refinance. This penalty will be less than the prepayment penalty on a similarly couponed fixed-rate loan. Prepayment expense cannot be predicted with certainty, but Chatham can provide borrowers with scenario analyses that show potential prepayment costs under different rate environments and hold periods. Swaps may also be structured with open prepay windows to limit potential prepayment costs. (Back to top)
How do swaps compare with interest rate caps?
Interest rate caps are also commonly used to hedge floating-rate loans. Comparing the two:
- Swaps create a fixed-rate profile while caps establish a known worst case for a floating rate, while permitting the borrower to pay the floating rate below the cap “strike.”
- Swaps are most often structured without any upfront payment to the counterparty and often must be done with the associated lender. A cap requires an upfront cash payment but may be purchased from providers other than the lender.
- Swaps may become liabilities over time and require a cash breakage payment if terminated early. Provided that their premium is paid upfront, caps are never liabilities to the purchaser, and, therefore, won’t create the risk of a future cash breakage payment. (Back to top)
How are my loan and swap related?
While a loan and its associated swap are documented as two distinct contracts (the loan being governed by the loan agreement and related documents and the swap by an ISDA and its related documents), there are typically provisions in these documents tying them together. The loan may state that the swap is mandatory, with a default or termination of the swap triggering a default on the loan. Conversely, a default on the loan will typically trigger a default on the swap. Prepayment provisions may also tie the two together, with a payoff of the loan triggering a termination and settlement of the swap. (Back to top)
What is swap breakage? How do I calculate swap breakage?
Swap breakage is analogous to the prepayment of a fixed-rate loan. It represents the amount payable by one party in the swap transaction to the other to terminate the position. This may be due to a sale or refinance of an underlying asset. It is based on a comparison of the original, contracted swap rate with the then, market replacement rate for the remaining term. If the original rate exceeds the current replacement rate, the borrower will pay the swap provider to terminate the swap. Conversely, if the contractual rate is less than the replacement rate, the borrower will receive a payment from the swap provider. This “two-way” breakage is one of the key differentiators of swap termination relative to fixed-rate loan prepayment — it can be a benefit to the borrower.
Most swaps are structured to cover the loan term, and, therefore, it is common to terminate the swap if the loan is repaid early (unless the swap was executed on an unsecured basis or with collateral other than the underlying asset).
Swap breakage is important because it reduces the prepayment flexibility that a pure floating-rate loan would allow. Borrowers should consider swap prepayment exposures ahead of closing a transaction, particularly if there is an expectation to sell or refinance the property before the loan/swap maturity. Much like a prepayment penalty on a fixed-rate loan, a swap termination payment can substantially change the economics of a sale or refinance. Chatham can advise you and contextualize potential swap breakage costs in advance of closing.
An example of swap breakage:
- Borrower locks in a swap rate of 1% at the closing of a $25M loan for the next 10 years
- Five years later, the borrower is looking to break the swap in connection with a refinance or sale
- The “replacement rate” is a calculation of the cost compared to the contract swap rate of 1% to the prevailing 5-year mid-market swap rate (for five years remaining on the swap
- If the replacement rate is 50 bps, the swap breakage that the borrower pays would be, in rough terms, (1% - 0.50%) x 5 years x $25M = $625,000
- If the replacement rate is 150 bps, the borrower would receive, roughly, (1.50% - 1%) x 5 years x $25M = $625,000
- There will be some present value math involved, adjustments based on day-count conventions, and trading costs, but these numbers illustrate the magnitude of the payments (Back to top)
What happens if I sell/refinance my deal when I have a swap?
In cases where a swap is secured by the underlying asset, pari passu to the loan, the swap typically needs to be terminated if the underlying loan is prepaid. Most swap documentation for secured swaps will make it explicit that if the underlying loan is redeemed, this triggers a termination of the swap since the swap provider no longer has security. Similarly, many loan agreements specify that the swap must be terminated and settled as a condition to loan payoff.
In cases where a swap is unsecured by the underlying asset, a sale or refinance may not automatically trigger/necessitate a termination of the swap. It may not make sense to continue paying interest under the swap if there is no loan being hedged, so swaps will often be terminated in these situations as well. (Back to top)
My loan term is seven years, but I think I might sell my property in three years. Should I enter into a seven-year swap?
As with any loan that has prepayment risk, borrowers using swapped floaters should consider mismatches between the loan maturity and the expected sale/refinance date, as these mismatches can result in large prepayment penalties. Borrowers looking to manage this risk may consider the following:
- Swaps may be structured with fully or partially open prepay windows to limit potential prepayment costs. These features involve paying a premium in the rate in exchange for increased prepayment flexibility. This may take the form of an open window, or the form of a capped prepayment penalty. In this example, a borrower could embed full cancellability for the last four years of the swap. Once the cancellability option kicks in at the start of year four, a borrower is assured that they will never have to pay to terminate the swap, though they could still receive a payment if rates have risen sufficiently. If a completely open window adds too much to the rate, the borrower may structure the swap to have a capped prepayment penalty — say 1% of the loan balance.
- A borrower may negotiate with the lender to permit a swap term that is shorter than the loan term. In this case, the borrower might ask the lender to permit a four- or five-year swap. If a lender approves a structure like this, often they will require the borrower extend the hedge if the loan is still outstanding at the initial swap maturity date, which exposes the borrower to interest rate risk at that time.
- A borrower may consider an alternative hedge product with more prepayment flexibility, like an interest rate cap or a combination of a swap with a cap. Purchasing a cap for longer loan terms has a material impact on the premium cost and may require a significant upfront cash outlay. (Back to top)
Why is my swap such a large liability?
Swap values are market driven and will be liabilities to borrowers from day one equal to the present value of the credit charge. Swap mark-to-market values will move over time and can be assets or liabilities to borrowers depending on the contract swap rate relative to the market replacement rate at any given time for the remaining swap term. A swap will be a liability for a borrower if market replacement rates are lower than their contract swap rate. Furthermore, if the swap were to be terminated, the swap provider would expect to be made whole since they would receive a lower rate in the current market. (Back to top)
How can I get out of this large swap liability?
If you are selling or refinancing an asset which has a secured swap on it, you will typically be obligated to terminate the swap and pay the breakage cost.
There might a situation where you are refinancing the asset with the same lender that is willing to roll your existing swap liability into a new swap on the new loan. This is often referred to as a “blend and extend.” While this is a way to avoid paying swap breakage in cash outlay, you still pay for it over the term of the new swap in the form of a higher rate. (Back to top)
What is a "blend and extend"?
A “blend and extend” is a process in which a borrower embeds the liability of an existing swap position into a new swap and extends the maturity to cover the new loan term. It is done in lieu of terminating the existing swap, paying breakage, and putting a new swap on at current market rates. The existing swap liability is essentially paid over time via a higher rate on the new swap. This approach does not forgive swap liabilities, it merely defers them and may even increase them if a borrower doesn’t effectively negotiate the new swap rate. Embedding a pre-existing swap liability into the new loan increases the loan LTV, so this solution is typically only available when the loan is being refinanced with the incumbent lender. (Back to top)
Can swap breakage be more punitive than a prepayment penalty on a fixed-rate loan?
Swap breakage will always be less punitive than the prepayment penalty on a similarly couponed fixed-rate loan with common yield maintenance or defeasance penalties. Swap breakage is calculated by comparing swap rate to swap rate (which is just the base index). A prepayment penalty on a fixed-rate loan with defeasance or yield maintenance typically compares the full loan coupon to a Treasury yield or some other base rate. Put differently, fixed-rate loans often have spread maintenance while swap breakage does not. This is important to consider when comparing swapped floaters to pure fixed-rate loans. Even if a pure fixed-rate loan has a lower all-in coupon than a swapped floater, the prepayment dynamic can result in the swapped floater having a lower effective cost of debt over the life if the loan is prepaid. Another important feature is that swap breakage is usually “two-way,” with the borrower receiving a payment if rates have risen sufficiently. Fixed-rate loans are often “one-way,” so no matter which direction rates move there will never be value to the borrower. In many circumstances there is often a minimum prepayment penalty in a fixed-rate loan. (Back to top)
What is the ISDA and why is it important? Is it negotiable?
“ISDA” is an acronym for the International Swaps and Derivative Association, a trade organization for participants in the market for derivatives like swaps and caps. “The ISDA” is also reference to the industry-standard documentation used for derivatives. This documentation typically has two components: the ISDA Master (boilerplate, either the 2002 or 1992 version) and ISDA Schedule (transaction-specific and negotiable). While both are often presented to borrowers as boilerplate, parts of the ISDA Schedule may be drafted to be more or less favorable to a borrower, and these parts should be negotiated. While many outside counsel that represent borrowers have expertise in this area, others do not, making an expert advisor valuable. (Back to top)
What are the most commonly negotiated ISDA provisions?
Commonly negotiated areas include default and termination events (which can create cash events prior to loan maturity), ties to unrelated investments that could trigger defaults on the swap, and language which can tie non-recourse guarantors to swap obligations.
If not reviewed and negotiated carefully, the ISDA can potentially create backdoor default events on the swap. (Back to top)
What counterparty protections do I have?
It depends on the specific ISDA for the deal, but all ISDAs will have boilerplate default provisions that apply to both parties. Individual ISDAs may contain additional provisions that govern counterparty risk including additional termination events and entities/individuals that provide credit support. (Back to top)
Can I transfer/assign my swap to a different entity/asset if I pay off the loan early?
Default ISDA terms allow a swap to be transferred with the consent of both parties to the swap. In practice, however, swaps on mortgage debt will usually contain a provision which allows the swap provider/lender to terminate the swap if the loan is paid off. So, if the preference is to transfer/novate, this discussion needs to happen early to allow consent to be granted by the bank counterparties involved. (Back to top)
How will the LIBOR transition affect my swap?
For information on how the LIBOR transition may impact your swap, please see:
Ready to execute an interest rate swap?
Schedule a call with one of our advisors.
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.20-0397
Our featured insights
What happens now to LIBOR loans and hedges?
As we enter the month of July, we pass the June 30 date which represents the sunset of LIBOR and the discontinuation of its use in CRE loans. Chatham is fielding questions from a variety of CRE market participants (including many borrowers, lenders, and brokers) on what this event will mean for...
Term SOFR – daily SOFR divergence
Term SOFR is an index rate frequently used in floating-rate loans and notes. It is published by the Chicago Mercantile Exchange (CME Group) in tenors of one, three, six, and 12 months and reflects market expectations for spot SOFR (an overnight rate) for that given tenor. This piece examines...
Term SOFR execution charges in interest rate hedges
Term SOFR has emerged among non-Agency commercial real estate (CRE) lenders as the primary SOFR-based index of choice for their floating-rate loans. It is the NY Fed ARRC recommended fallback for non-agency CRE loans and the fallback under the LIBOR Act where the LIBOR Act applies. Regulatory...
Understanding recent changes in SOFR-based loan index rates
There has been a recent divergence between the different variations of SOFR used in commercial real estate (CRE) loans, with Term SOFR increasing while daily simple SOFR and New York Fed 30-Day Average SOFR remaining relatively flat prior to the Federal Reserve meeting and the other starting to...
GBP LIBOR’s last days, SONIA, and the start of synthetic GBP LIBOR
With only days to go until the final GBP LIBOR fixing, below is a short update on current state of transition and the emerging discussions on use of synthetic LIBOR.
Understanding LIBOR alternatives in CRE loans
Commercial real estate (CRE) lenders have begun to adopt SOFR and other LIBOR alternatives, presenting borrowers with different variations of these rates. This overview provides a summary of the common permutations of these rates and borrower considerations for each.
Hedging costs update — November 8, 2021
The Fed has started tapering its purchase of bonds, signaling a potential end to quantitative easing (QE). This has occurred in the context of a market that has pulled forward expected timing for a rate hike from the Fed. These factors have driven a rapid increase in hedging costs, particularly...
The finish line is in sight — GBP LIBOR transition
As the date for the final GBP LIBOR fixing nears, the work from the banking and advisory community to transition all outstanding contracts from LIBOR to the new RFR is gathering momentum. We have previously published articles on the background to the transition and how borrowers should prepare....