Restructuring interest rate derivatives for European publicly listed real estate investors
- June 18, 2020
Hedging and Capital Markets
Real Estate | London
SummaryInterest rates in Europe have been on a downward pathway since the end of 2018, accelerated recently by the monetary stimulus launched to deal with the economic fallout from global lockdown.
Many commercial real estate investors are exploring ways to restructure their hedging in order to:
- Take advantage of the lower rates now available in the market
- Reduce overall funding costs in the short term when rental income is under pressure
- Improve EPRA KPIs, such as EPRA earnings and EPRA earnings per share
How is this achieved?
When looking to lower interest expense, investors can restructure their interest rate swaps through re-couponing.
Re-couponing settles the mark-to-market of the existing instrument (in cash) and reduces the fixed swap rate to the lower market rate. This improved rate is then paid until the original maturity of the swap, essentially locking in the interest expense saving to maturity. The cost of such a strategy is approximately equal to that of the saving, save for transaction charges.
This will cause a cash event and the hedge counterparty will typically need to receive the settlement of the mark-to-market within two business days of the restructure.
What is the impact on key performance indicators (KPIs)?
For European publicly listed real estate investors who report KPIs in accordance with EPRA (European Public Real Estate Association) guidelines, changes in the fair value of financial instruments such as derivatives are excluded from EPRA earnings.
This is because the objective of EPRA earnings is to provide an indication of the underlying income performance generated from the leasing and management of the property portfolio in a way which enables comparison with other similar businesses. Including the fair value of hedging instruments in EPRA earnings would not provide consistent comparability of the core property business across companies.
Therefore, fair value of derivatives, such as interest rate swaps used to hedge the interest rate risk, would not affect EPRA earnings. Furthermore, the restructure of financial instruments with a maturity date ending beyond the current reporting period would also be excluded from EPRA earnings.
Interest payments on derivatives such as interest rate swaps, however, are recorded in EPRA earnings. This means that the benefit of the restructure, in the form of lower ongoing interest expense, is recorded in EPRA earnings whilst the cost of the restructure is excluded1.
The resulting lower interest expense could improve headroom on interest-linked financial covenants such as ICR and DSCR and improve other financial KPIs such as EPRA earnings per share.
Risks and considerations
Eligibility: Re-couponing the swap rate should improve the lender’s credit position and should be a straightforward process. The swaps should not already be designated as cash flow hedges.
Liquidity: Re-couponing out of the money swaps will require paying the existing swap liability to the bank, making this unsuitable for borrowers who may be facing immediate liquidity constraints.
Market risk: The cost of the swap breakage will vary depending on prevailing market conditions at the time of restructure.
In 2019, a borrower with a £10 million loan maturing June 2023 priced at LIBOR + 2.00% and swapped to fixed at 1.50% pays the swap breakage cost of £395,000 and re-coupons the swap rate at 0.19%, bringing the all-in coupon down to 2.19% for the remaining term.
We assume that the borrower is not applying hedge accounting and the swap was re-couponed on the last day of the previous financial year for £395,000. The mark-to-market of the re-couponed swap on the last day of the current financial year is a liability of £50,000.
The swap breakage cost represents a cash crystallisation of derivative mark-to-market movements that impact IFRS earnings but which are excluded from EPRA earnings. Whilst, the reduction in interest payments post-restructure impacts both IFRS earnings and EPRA earnings, it results in an improvement in EPRA earnings per share.
Summary and next steps
Re-couponing swaps allows EPRA-reporting CRE investors to immediately reduce interest expense and see improved EPRA earnings. Any borrower undertaking this restructure should ensure to market benchmark the economics and trading costs, and fully understand the risks and benefits of the exercise.
Please feel free to reach out to your Chatham representative if you would like to further evaluate the availability and suitability of such a transaction.
1Calculating EPRA earnings is potentially more complex in situations in which the company is applying hedge accounting to their underlying IFRS numbers.
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.20-0202
Our featured insights
The hairy chart: Historical accuracy of LIBOR forward curves
These hairy chart graphs plot past LIBOR forward curves against the actual path LIBOR followed, showing that the forward curve has been a somewhat accurate predictor over the next six months or so...
Capital markets and accounting considerations in real estate M&A
Mergers and acquisitions involve a multitude of complexities and risks. Speed and accuracy at every stage of an acquisition is critical to not only winning the deal but also giving the transaction the best chance of financial and strategic success. Financial risk associated with the valuation of...
GBP LIBOR transition for derivatives and use of the ISDA fallbacks
Many loans and derivatives are now in the process of being transitioned to SONIA, and there is a clearer pathway; with prior issues and obstacles being addressed. This piece presents the current position in the market and provides a pragmatic solution for borrowers who may not need, or want to,...
A tour of Europe — an update on interest rates
A brief update on the EUR, SEK, and GBP interest rate conditions, putting the recent year-to-date movements into the context of the last 12 months.
Request your interest rate cap execution checklist
Understanding the tactical steps involved in executing on an interest rate cap can help CRE investors plan and use their time efficiently prior to closing on a loan. Request your interest rate cap execution checklist here.
Thought leadership for housing associations: Embedded swaps and SONIA
There is emerging evidence that the way the housing association sector hedges its interest risk will change in the coming year. Currently, most are able to fix the debt through an embedded swap (a fixed-rate loan or “FRL”). FRLs account for the majority of fixed-rate borrowing for most small to...
Steepening yield curve increases cost of GBP interest rate hedging
A series of government bond selloffs have jolted financial markets since the start of 2021. In the UK, one consequence is a sharp rise in the cost of hedging GBP interest rate exposures. Having started the year at 0.08%, the five-year swap rate on 3-month GBP LIBOR hit 0.52% at the end of...
LIBOR transition timing update — the regulators have spoken
This piece summarizes a series of public announcements on March 5 regarding the timing of LIBOR cessation. Most notably, one- and three-month USD LIBOR will be published through June 30, 2023, while all non-USD LIBOR settings (GBP, EUR, CHF, JPY) will be published through December 31, 2021....