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Presenting a live 90-minute webinar with interactive Q&A

Swap Documentation in Real Estate Loan Transactions: Coordinating ISDA Master Agreement and Loan Agreement Terms

Documenting Covenants, Security, Required Consents, Voting and Control, Reporting, and Regulatory Issues Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific WEDNESDAY, OCTOBER 26, 2016

Eddie Frastai, Partner, Clifford Chance, New York Jeffrey Koppele, Partner, Dentons, New York

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Swap Documentation in Real Estate Loan Transactions:

Coordinating ISDA Master Agreement and Loan Agreement Terms

Strafford Webinar

October 26, 2016

Introduction

October 26, 2016

Jeffrey H. Koppele

Partner Capital Markets/Tax Dentons D +1 212 768 6916 jeffrey.koppele@dentons.com

Eddie Frastai

Partner Real Estate Clifford Chance LLP D +1 212 878 4931 eddie.frastai@cliffordchance.com

[Eddie to supply picture]

6

Agenda

October 26, 2016

• Introduction: Interest Rate Risk in Real Estate Financings
• Hedging Interest Rate Risk: Rate Caps and Interest Rate Swaps
• Integrating Hedge Agreements Into Loan Documentation
• Regulatory Issues: Dodd-Frank
• Negative Interest Rates

7

Interest Rate Risk in Real Estate Loans

October 26, 2016

• A commercial mortgage loan often bears interest at a floating rate.
• Floating rates can rise quickly at any time.
• Rental income of the property owner/borrower generally changes gradually.
• A spike in interest rates is thus a risk for borrower (and lender).

8

Mitigating Interest Rate Risk

October 26, 2016

• Lender often requires borrower to mitigate the risk of interest rate volatility.
• A hedge is a form of "derivatives contract."

– Derivative: an agreement whose value is derived from the value or amount

• f an underlying index, asset or event.

– Here the index is an interest rate, usually 1-, 3- or 6-month LIBOR.

9

Rate Cap

October 26, 2016

• The most common hedge in commercial real estate finance is a rate cap.
• Borrower purchases rate cap from a counterparty, usually a bank ("Rate Cap

Provider").

• Borrower pays to Rate Cap Provider a fixed amount at the inception of contract.
• Rate Cap Provider pays to borrower the excess, if any, of LIBOR over a

specified Strike Rate, periodically over the term of the contract. Borrower Rate Cap Provider

LIBOR - Strike Fixed Upfront Payment

Rate Cap cashflows:

10

• Lender determines the strike rate for the Rate Cap, based on the property's

expected cashflows/interest coverage.

• Rate Cap sets a cap on the Borrower's effective interest rate under the loan.
• Rate Cap and Loan periodic cashflows:
• Rate Cap Provider pays the excess of LIBOR over the Strike rate.
• Borrower's effective interest rate is capped at Strike + Spread.

Rate Cap

October 26, 2016

Lender Borrower Rate Cap Provider

LIBOR - Strike LIBOR + Spread

Rate Cap: Loan:

X X

11

• Facts

– Loan interest rate: LIBOR + 1% – LIBOR at closing: 2% – Strike Rate on Rate Cap: 3% – Borrower net cost capped at Strike + Margin 4%

• If rates go up, Rate Cap proceeds fund Borrower's increased LIBOR cost.

– Example: LIBOR increases to 4% □ Borrower pays Loan interest rate: 4% + 1% = 5% □ Borrower receives from Rate Cap Provider: 4% - 3% = 1% □ Borrower net borrowing cost: 5% - 1% = 4% – Example: LIBOR increases to 6% □ Borrower pays Loan interest rate: 6% + 1% = 7% □ Borrower receives from Rate Cap Provider: 6% - 3% = 3% □ Borrower net borrowing cost: 7% - 3% = 4%

Borrower Cost Capped Whether LIBOR Rises or Falls

October 26, 2016 12

• Facts

– Loan interest rate: LIBOR + 1% – LIBOR at closing: 2% – Strike Rate on Rate Cap: 3% – Borrower net cost capped at Strike + Margin 4%

• If rates go down, property cashflow funds Borrower's Loan interest rate.

– Example: LIBOR decreases to 1% □ Borrower pays Loan interest rate: 1% + 1% = 2% □ Borrower receives from Rate Cap Provider: 0% (LIBOR less than Strike Rate) □ Borrower net borrowing cost: 2%

Borrower Cost Capped Whether LIBOR Rises or Falls

October 26, 2016 13

Disparate Objectives of the Parties to Rate Caps

October 26, 2016

• Lender – robust cap
• Borrower – minimize cost
• Rate Cap Provider – high-volume, low-profit transaction
• Parties' disparate objectives can and frequently do result in risks for the

Lender and Borrower.

• Many of these risks are avoidable.

14

Rate Cap Provider Downgrade

October 26, 2016

• Rate Cap Risks

– Cap Provider bankruptcy or insolvency

• Rate Cap typically includes a "downgrade" provision:

– Cap Provider credit rating must exceed a specified threshold at closing. – If Cap Provider rating drops below a specified trigger, Cap Provider must either post collateral or replace itself. – If Cap Provider rating drops below a second trigger, Cap Provider must replace itself (and must post collateral until replacement is accomplished).

15

Advantages

• No ongoing borrower payment
• bligations (after payment of

upfront premium)

• Borrower benefits from decline in

floating rate

• Typically assignable by borrower
• Borrower may receive, but will

never be obligated to make, a termination payment.

Advantages and Disadvantages of Rate Caps

October 26, 2016 16

Disadvantages

• Rate cap requires upfront

premium

• Cost increases with duration
• Rate caps typically limited to three

years

• An interest rate swap converts Borrower's floating rate obligation to a fixed rate.

– Borrower makes periodic payments to swap provider at a fixed rate. – Swap provider makes periodic payments to Borrower at LIBOR. – Payments are netted; party with the greater obligation pays the difference.

Interest Rate Swaps

October 26, 2016 17

Lender/Swap Provider

Borrower

LIBOR + Spread

• ------- Swap --------
• ------- Loan --------

X

LIBOR

X

Fixed Rate

• If LIBOR goes up/down:

– If LIBOR exceeds the Fixed Rate, Borrower receives money under the Swap, but its Loan interest payments are higher. – If LIBOR remains below the Fixed Rate, Borrower pays money under the Swap, but its Loan interest payments are lower.

• Regardless of LIBOR, Borrower's effective Loan interest rate is equal to the

Swap Fixed Rate plus Loan Spread.

• Unlike a rate cap, a swap usually has no upfront fixed payment.
• Lender may act as swap provider.
• Borrower typically pledges its rights under the Swap to Lender as additional

collateral for the Loan.

Interest Rate Swaps

October 26, 2016 18

Advantages

• No upfront payment required
• Longer durations available
• Fixed/swapped rate will not

change over time

Advantages and Disadvantages of Interest Rate Swaps

October 26, 2016 19

Disadvantages

• Borrower does not benefit from

decline in floating interest rate

• Borrower has ongoing payment
• bligations. Therefore:

– Swap provider typically requires collateral or other credit- worthiness – Two way termination payments possible

• Typically not assignable by

borrower

Acquiring/Pricing a Rate Cap or Swap

October 26, 2016 20

• Rate caps:

– To obtain best pricing, borrower (or its advisor) typically holds an auction for the rate cap. – Often, between 2-4 financial institutions bid on rate cap, based on terms provided in a "bid package".

• Swaps:

– Greater challenge regarding pricing. – Because borrower has ongoing borrower payment obligations, swap providers typically require collateral. However, a lender typically will not permit borrower's obligations to an unaffiliated hedge provider to be secured by the property. – Borrowers thus are generally compelled to execute swaps with the lender.

• Documents Affecting Hedge Agreement

– Loan Application – Loan Agreement/Promissory Note – Collateral Assignment of Hedge – Bid Package – Hedge Documentation – Dodd-Frank Protocols

Loan and Hedge Documentation

October 26, 2016 21

ISDA Master Agreement Schedule Confirmation(s) ISDA Definitions

• - or --

"Long-form Confirmation"

Counterparty Risk

October 26, 2016 22

• Default by Hedge Provider will trigger replacement obligation on Borrower under

Loan Documents

• Ways to Mitigate Counterparty Risk:

– Require Hedge Provider to post margin equal to value of Hedge – Require Hedge Provider to replace itself – Require Hedge Provider to provide a guaranty from a creditworthy affiliate

Security for Borrower's Swap Obligations

October 26, 2016 23

• Borrower is typically required to be an SPE
• Swap Provider requires collateral for Borrower's future swap payment obligations

(N/A for rate cap).

• Lender will not agree to make its collateral (i.e., the property) available to Swap

Provider as collateral, unless Lender itself is also providing the Swap.

• Swap Provider may accept guaranty from creditworthy affiliate of Borrower

instead of taking security interest in the property.

Definite Obligation

October 26, 2016 24

• Various states require mortgage to state the principal amount or definite
• bligation to be enforceable.
• Borrower obligations under a Swap do not involve the repayment of principal and

are indefinite.

• If mortgage intended to secure Borrower's obligations under Swap, and:

– Lender and Swap Provider are identical  characterize swap payments as interest payments (potential savings on mortgage recording taxes too). – Lender and Swap Provider are affiliates  characterize swap payments as

• bligatory advances, which may "relate back" in various states.

– Lender and Swap Provider are not affiliated  mortgage most likely not available to Swap Provider.

Documentation Tips: Entering into Hedge Agreement

October 26, 2016 25

• Tighten Bid Package

– Defined terms in Hedge should match defined terms in Loan Documents (e.g., floating rate, rounding, business day, payment date, strike rate, maturity date). – Consider requiring more stringent downgrade trigger of Hedge Provider than trigger in Loan Documents. – Require payments be made directly to account controlled by Lender.

• Confirm that confirmation conforms to Bid Package.
• Include downgrade triggers in Collateral Assignment.

Selected Loan Agreement Provisions re: Hedge

October 26, 2016 26

• Conditions Precedent re: Hedge Agreement

– Broad outline of hedge terms, e.g., rate, term, notional amount – Swap provider consent to collateral assignment – Hedge reasonably satisfactory to Lender (or Agent)

• Borrower Covenants

– Maintain hedge agreement over specified term – Replace hedge upon swap provider downgrade – Hedge covering loan extension period

• Lender consent to modifications or termination of hedge agreement
• Borrower obligation to pay interest unaffected by hedge agreement

Selected Loan Agreement Provisions re: Hedge

October 26, 2016 27

• Failure to maintain hedge constitutes a borrower event of default
• An event of default under the hedge is typically a borrower event of default
• Application of hedge proceeds

– In general – Upon hedge event of default or termination event

• Waterfall

– Borrower swap payments to lender/hedge provider – Borrower swap payments to unaffiliated hedge provider

Loan Provisions Relating to Hedge Calculations

October 26, 2016 28

• Floating Rate in Loan Agreement and Hedge Should Match
• Notional Amount

– Fixed – Stepdown – Overhedging: Optional or Mandatory Partial Breakage

• Breakage

Regulatory Issues: Dodd–Frank

October 26, 2016

• Dodd-Frank Title VII—Regulation of Over-the-Counter Swaps Markets
• Dodd-Frank can have a significant effect on hedges, particularly where a swap,

rather than a rate cap, is used.

• Key issues:

– Eligible Contract Participant (ECP) □ Borrower and every co-obligor and guarantor of swap cashflows must qualify as an ECP □ Generally, to qualify as an ECP an entity must have:

• Total assets of at least $10 million, or
• Net worth of at least $1 million, if swap if is in connection with its

business or hedging its assets or liabilities – "End User" Clearing Exemption – Swap Reporting - obligation of the Swap Dealer

29

Negative Interest Rates

October 26, 2016

• Central Bank policy initiative to encourage banks to lend rather than hoard cash
• Lenders likely to increase interest rates to recover higher cost of maintaining

funds on deposit with Central Bank

• Floating Rate Loans

– Loans that include a LIBOR floor □ Floor could result in mismatch with rate payable under hedge. – Loans without a LIBOR floor □ Would a Lender be required to make interest payments to the Borrower? □ Erosion of margin?

30