What will your swap actually cost at closing?
Hedging and Capital Markets
Real Estate | Kennett Square, PA
Interest rate swaps are one of the tools that commercial real estate borrowers can use to manage the risk associated with floating rate loans.
Oftentimes, borrowers choose to enter swaps with the rationale that they are “free”, especially when compared to an interest rate cap that typically requires an upfront payment. However, swaps are certainly not free, and can have a significant cost or “fee” if not negotiated carefully.
What fee is that, you might ask? Well, we are talking about the swap fee, credit charge, or mark-up. It goes by many names, but it is ultimately the overhead and profit that a lender embeds into the swap rate in excess of the mid-market swap rate. The mid-market swap rate, which reflects a swap provider’s cost, is the rate at which two credit-worthy banks would transact if one wanted to pay fixed and the other wanted to receive fixed in the same swap structure. The fixed rate that a real estate borrower agrees to pay in a swap is the combination of this mid-market rate and the credit charge the bank will add to the rate at execution.
How does this happen? Don't lenders have to disclose all of their fees?
Let’s consider an example. A bank issues a term sheet for a floating rate loan at 1-month LIBOR plus a loan spread, say 2.00%. The term sheet states that the borrower will be required to swap the floating rate to a fixed rate of interest and that the current all-in rate would be 5.0% (this all-in rate is equal to the 2.00% loan spread plus the fixed swap rate). On the surface, this may seem okay. But what is not disclosed is the fee the bank plans to embed in the swap. If the bank’s mid-market swap rate is 2.70%, they have added 30 basis points to the swap rate. On a $25mm, 7-year loan this amounts to a present value of about $490,000. Dodd-Frank requires banks designated as swap dealers to disclose their mid-market swap rate at the time a swap is entered into, but not when a term sheet is provided to a prospective borrower. This means that in our example, a borrower may only learn at closing that the bank is charging 30 basis points on the swap. Of course, it’s probably too late at that point to question a swap fee of 30 basis points, at least without delaying the closing.
As mentioned, Dodd-Frank requires swap dealer banks to disclose their mid-market swap rate at swap execution. But they will tell you (and it’s true) that the Dodd-Frank mid-market swap rate does not accurately reflect their cost to provide the swap. A swap is a credit intensive product, and as such, there is a cost for a bank to face a real estate borrower. Chatham models thousands of trades every month-end, and for many of them we calculate a Credit Valuation Adjustment or “CVA” that takes into account the potential for losses due to a counterparty default. The CVA that we calculate roughly reflects a bank’s cost to provide a swap. For an L+2.00% borrower, this cost is roughly 10 basis points on a 7-year term. The additional swap fee (20 basis points) goes to cover the cost to maintain a derivatives desk and, of course, to profit.
What can you do?
We know that reliable access to real estate debt capital is the lifeblood for most of our commercial real estate clients. So what can be done that won’t damage your lending relationships? First, discuss the credit charge for any swap with potential lenders before you sign a term sheet, and ask them to disclose it in the term sheet. You can tell them that you are trying to assess the whole picture of the proposed loan before making a decision, and that the swap credit charge is important in that analysis. Agreeing on a swap credit charge, expressed in basis points, will allow both parties to know what the all-in loan rate will be even as the underlying mid-market rate fluctuates between term sheet signing and closing. While this does not prevent the rate from potentially rising during this time, you will know the final rate you pay is what you negotiated. In our experience, if the swap credit charge isn’t agreed to upfront, it is likely your rate will go up, at least in accordance with market movements. But you may not get a corresponding movement if rates fall.
You take into account all the fees, expected interest costs, proceeds, covenants, and prepayment characteristics when selecting a lender, right? Don’t leave out of your analysis what could be the biggest fee of all!
To learn more about interest rate swaps, contact Chatham's real estate team
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.
Our featured insights
The major U.S. equity indices moved higher for the week amid stimulus bill negotiations on Capitol Hill, rising tensions between the U.S. and China, and a deluge of economic data releases.
A forward curve for a market index is, at a discrete moment in time, a graphical representation of the market clearing forward rates for that index.
The Agencies are on track to transition to SOFR as an index for floating-rate loans by EOY. Applications for SOFR indexed loans may be seen as early as this month. Liquidity of SOFR interest rate caps is limited but Chatham is optimistic that they will be available for closing these loans.
The interest rates on which CRE investors focus are comprised of real rates, inflation expectations, and credit spreads. Understanding how macroeconomic conditions impact these components and a good risk management policy provide a framework for managing interest rate risk.
In reviewing what has transpired in the commercial real estate (CRE) lending markets over the past six months, we found it helpful to re-read our market commentary as it was written at the end of each of the last three quarters.
After a record 20.4% monthly contraction in UK GDP in April, the expectation was that with some businesses able to reopen under strict conditions in May, there would have been a solid rebound in output.
Now that we’re halfway through 2020, let’s examine how we got here and what the second half of the year might bring.