Navigating hedging decisions for REITS during the COVID-19 crisis

The unusual environment in which we find ourselves requires us to tackle issues we may not have encountered before.

What are some of these issues, and why are they important today?

LIBOR floors

• Language in loan agreements flooring LIBOR at 0% has been common in the U.S. for several years now. While USD LIBOR has never gone negative, it remains a possibility. The 0% LIBOR floor language became the norm in U.S. loan agreements around 2014–2015, as banks responded to regulators first using negative interest rate scenarios in their shock tests on bank balance sheets.
• When entering into a hedge on a floored debt instrument, specifically an interest rate swap, one must consider whether or not to embed (i.e., purchase) the matching LIBOR floor in the swap. For REITs, this is both an economic decision and an accounting decision. With 1-month LIBOR now below 0.2% (as of this publication) and projected to move lower, qualifying for hedge accounting cannot be assumed; either upfront, or at a later time. Volatility to earnings could be a result, and one REITs would prefer to avoid.
• Non-zero LIBOR floors in new, or restructured, debt agreements add further complication. These can be 0.25%–1% and sometimes higher. This is when alternate hedging products, other than swaps, should be considered.
• Borrowers should be aware of the impact of LIBOR floors, not only on interest expense, but also on the viability of certain hedging products and the application of hedge accounting.

Forbearance

• Many real estate borrowers are entering into discussions with their lenders about forbearance. This topic becomes more complicated when there is a swap associated with the debt.
• The debt and swap are separate instruments, even if both are with the same banking institution. Negotiating a forbearance on your loan does not automatically carry over to the swap. Many banks are offering to restructure the swap by delaying swap interest payments in exchange for a higher coupon on the restructured swap. Close attention to the pricing of the revised swap rate is critical to understand what further transaction costs or funding charges are being applied by the bank.
• Any restructuring of a hedge that is designated for hedge accounting must avoid unintended consequences, such as new income statement volatility resulting from a failure to qualify for hedge accounting. New hedge documentation requirements must be completed in a timely manner.
• Borrowers will also want to pay close attention to any other amendments to the loan documents that the lender proposes outside of the forbearance mechanics. Lenders may take this opportunity to make other changes, such as spread or floor adjustments. It is important to understand these changes and to ensure they do not negatively impact any in-place hedging arrangements, especially changes to, or the introduction of, a LIBOR floor.

Forward hedging

• A common hedging strategy among REITs is pre-issuance hedging — a forward hedge of a future intended debt issuance, whether through public markets or a private placement. The current market conditions have caused most, if not all, real estate borrowers to carefully reconsider and revisit their capital markets plans. One scenario could be a REIT that has existing forward swaps or Treasury locks in place, which were originally economically structured and designated for hedge accounting with a certain debt type and issuance time frame in mind. With a change in debt needs and time frame, should the hedges be unwound? Are there ways to restructure or extend the hedges, so that they can continue to be used for a future issuance, when that day comes? Does the right economic answer align with the best accounting answer, and which is more important? And how important is cash preservation, relative to other concerns? Addressing these questions should guide the borrower to the correct response for their own situation.

New hedges

• With LIBOR approaching all-time lows and an inverted forward curve, now could be considered a great time to enter into new hedges. However, it is important to understand that the current market has caused considerable dislocations in pricing and efficiency of execution:
  • Pricing for option products like interest rate caps has been more volatile
  • Decreased liquidity has caused widening bid-ask spreads
  • A worsening credit market has inflated charges for credit-based products such as swaps
• In addition, there is more divergence than is typical between banks when it comes to pricing and execution charges. The banks that you’ve always known to be the best-priced and reliable hedge liquidity providers may no longer be leading the pack. Be in tune to these changing dynamics to optimize pricing and execution. Due diligence and price discovery are more critical than ever, as market conditions change daily, or even hourly.

In today’s world, negotiating confidently can be a challenge. Now more than ever, it is critical to understand the full ramifications and consequences of hedging terms, both economically and from an accounting perspective. Knowing how to marry changes to loan terms with hedge terms needs early attention in any negotiations. Pricing is more opaque than ever, and banking counterparties’ behavior is shifting. This situation is a dynamic and evolving one and will differ depending on the lender, the sponsor, the deal-type, and timing, among other factors. Chatham’s team of derivatives and hedge accounting experts can help you navigate it.