Interest Rate Hedges in Real Estate Finance
I recently presented a national webinar explaining interest rate swaps, caps and floors. I had the pleasure of presenting with Chrys A. Carey, counsel with Morrison and Foerster in Washington D.C. I have written before on the growing interest in these hedge agreements. Chrys and I and a number of the “attendees” of the webinar agreed that hedge agreements such as interest rate swaps and forward swaps are becoming more a part of commercial real estate transactions.
Chrys and I brought different perspectives to our presentation. While I am involved with the borrower or lender, Chrys has much more knowledge with the regulatory side of hedge providers and traders under the Commodity Exchange Act and the Dodd-Frank Act Regulations. Despite these different perspectives, our overlap in experience brought up some interesting discussions. Some of those are:
- What happens after LIBOR? Most hedge agreements use LIBOR as the standard for interest rates. Luckily, most of the variable interest rate loans that are involved in these transactions also use LIBOR as the standard interest rate. As you may know, LIBOR is set to be discontinued sometime in the next few years. Chrys believes the hedge providers and exchanges will settle on one single benchmark interest rate (such as the Wall Street Journal Prime Rate).
The potential problem is with local lenders. Variable interest rate loans that are not involved in an interest rate hedge have many different interest rate benchmarks. Lenders and (especially) borrowers will need to make sure the interest rate benchmarks line up after LIBOR is discontinued. Chrys believes that it will be harder for local and regional lenders to come to an agreement on a single benchmark to replace LIBOR. Lenders and borrowers will need to understand the interest rate benchmark as soon as possible in the negotiation.
- What is the security for the interest rate swap? The question of how the variable rate loan and the interest rate swap agreement are secured will always be important in any transaction where an interest rate hedge is present. Just like the interest rate benchmark, the parties need to make sure that the security provisions are consistent between all the loan documents. This does not mean that they will be the same. Because default provisions are usually different between the initial variable rate loan and the interest rate swap agreement, the lender and borrower need to understand the effect of these provisions on the original variable rate loan.
These are all important considerations that go to the heart of the deal. Very often, they are not issues that can be solved with a revision to the loan agreement the day before settlement. Rather, they affect the overall financial consequences of the deal. Because of that, all parties need to be aware of them as soon as possible in the process.