Presenting a live 90-minute webinar with interactive Q&A Interest Rate Hedges in Real Estate Finance: Placing Swaps, Caps, and Collars on Floating Rate Loans Understanding Pricing and Trade Confirmations, the ISDA Master Agreement, Counterparties, Current Regulation of Derivatives WEDNESDAY, FEBRUARY 22, 2017 1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific Today’s faculty features: Jeffrey H. Koppele, Partner, Dentons US , New York Mark Heimendinger , Of Counsel, Lowndes Drosdick Doster Kantor & Reed , Orlando, Fla. The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10 .
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Introduction Jeffrey H. Koppele Mark E. Heimendinger Partner Of Counsel Dentons US LLP Lowndes, Drosdick, Doster, Kantor & Reed, P.A. New York, NY Orlando, FL D: 212-768-6916 D: 407-418-6271 jeffrey.koppele@dentons.com Mark.Heimendinger@lowndes-law.com 5 February 22, 2017
Agenda • Introduction: Interest Rate Risk in Real Estate Financings • Hedging Interest Rate Risk: Rate Caps and Interest Rate Swaps • Placing the Rate Cap or Swap • Hedge Specific Documentation • Loan Agreement Terms Relating to Hedge • Regulatory Issues: Dodd-Frank 6 February 22, 2017
Interest Rate Risk in Real Estate Loans • 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). 7 February 22, 2017
Mitigating Interest Rate Risk • Lenders often require the 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 of an underlying index, asset or event. – Here the index is an interest rate, usually 1-, 3- or 6-month LIBOR. 8 February 22, 2017
Rate Cap • The most common hedge in commercial real estate finance is a rate cap. • Essentially an interest rate insurance policy with an upfront premium. • Rate cap provider pays the excess, if any, of LIBOR over a specified Strike Rate. • Notional amount typically equal to loan principal amount and may amortize; duration usually equal to initial loan term, excluding extensions. Rate Cap Cashflows LIBOR - Strike Rate Cap Borrower Provider Upfront Payment 9 February 22, 2017
Combining Rate Cap and Loan • Rate Cap sets a cap on the Borrower's effective interest rate under the loan. • Lender typically determines the strike rate for the rate cap based on the property's expected cashflows/interest coverage. • Borrower's effective interest rate is capped at Strike + Spread. Combining Rate Cap and Loan Cashflows X X Rate Cap LIBOR + Spread LIBOR - Strike Lender Borrower Provider Loan Rate Cap 10 February 22, 2017
Advantages and Disadvantages of Rate Caps Advantages Disadvantages • • Rate cap requires upfront premium. No ongoing borrower payment obligations under the rate cap (after • Cost increases exponentially with payment of upfront premium). duration. • Borrower will benefit from declines • Rate caps typically limited to three in the floating rate. years. • Borrower may receive, but will never be obligated to make, a termination payment. • Typically assignable by borrower. 11 February 22, 2017
Borrower Cost Capped Whether LIBOR Rises or Falls • Assumptions – Loan interest rate: LIBOR + 1% – LIBOR at closing: 2% – Strike Rate on Rate Cap: 3% – Borrower net cost capped at Strike + Margin 4% • If LIBOR goes up, Rate Cap proceeds fund Borrower's increased interest cost. – 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% • If LIBOR goes down, cashflow from property funds Borrower's interest cost. – 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% 12 February 22, 2017
Interest Rate Swaps • A swap is an exchange of a floating interest rate (e.g., LIBOR) for a fixed interest rate (e.g. 2.5%). Typically no upfront payment is required. • Fixed rate will be a “swap rate” determined by the swap provider at the time of the trade (not selected by borrower or lender). • Notional amount and duration are typically the same as for a rate cap. • Fixed Rate and Floating Rate payments are netted against each other. Swap Cashflows LIBOR Swap Borrower Provider Fixed Rate 13 February 22, 2017
Combining Swap and Loan • Swap converts Borrower's floating rate obligation to a fixed rate. • If LIBOR rises, Borrower receives cash under swap, pays higher loan interest rate. • If LIBOR falls, Borrower pays cash under swap, pays lower loan interest rate. • Borrower's effective financing cost: Fixed Rate plus Loan Spread. Combining Swap and Loan Cashflows X LIBOR X Swap LIBOR + Spread Lender Borrower Provider Fixed Rate Loan Swap 14 February 22, 2017
Advantages and Disadvantages of Swaps Advantages Disadvantages • • Borrower does not benefit from decline in No upfront payment required. floating interest rate. • Longer durations available. • Borrower has ongoing payment obligations. Therefore, swap provider typically requires collateral or other creditworthiness. • Fixed/swapped rate will not change over time. • Two way termination payments are possible. • Typically not assignable by borrower. 15 February 22, 2017
Creditworthiness/Collateral Issues re: Swaps • Borrower has ongoing payment obligations under a swap. • Swap Provider will request to be secured party. • Identity of the swap provider: – Lender vs. loan syndicate member vs. unrelated party • Intercreditor issues, even where Lender and Swap Provider are same entity. • Consider requiring Borrower to use an affiliate to enter into swap. – Avoids giving swap provider a security interest in the property. 16 February 22, 2017
Disparate Objectives of the Parties to Rate Caps • 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 may be minimized. 17 February 22, 2017
Rate Cap Provider Downgrade • 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). – Certain Cap Providers use parent guarantor to provide the necessary rating. 18 February 22, 2017
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