Thursday 14 April 2016
Negative rates causing headaches and increased costs for property investors says CREFC Europe
Negative interest rates are driving up the costs of real estate lending, property chiefs have warned.
- CREFC Europe warns negative rates can cause potential mismatches between loans and associated interest rate hedging
- For new deals, an interest rate floor in the loan should be matched by an interest rate floor in any associated swap – which will cost extra in the current environment
- For old deals, borrowers should audit loan agreements and associated swaps to identify cases where an interest rate floor in the loan is not matched by an interest rate floor in the swap
There has been widespread criticism of the European Central Bank (ECB) reducing interest rates. Moody’s warned last month of “potentially adverse effects on final stability” in Sweden. Similar reports around a housing bubble in Denmark have been echoed by Larry Fink, chief executive of BlackRock.
At a Commercial Real Estate Finance Council (CREFC) Europe seminar in London last night, experts warned that commercial property investors face new considerations and costs on new deals, and potential problems in historic deals. This is because specific provision needs to be made, and the associated cost paid, to include an interest rate floor in an interest rate swap. While that has become a sensible precaution in the current interest environment, it certainly wasn’t routine a few years ago.
With the potential for rates to decline further (see note 2 below), this will be a concern to many.
The problem of hedging interest rates
In effect, and at a cost, interest rate swaps allow a borrower to convert a flexible floating-rate loan into a fixed-rate liability that its rental income is expected to cover.
While loan agreements can include a safety net so that floating interest rates stop at zero (to prevent lenders having to pay borrowers), many older interest rate hedging derivatives don’t do that; a typical interest rate swap would not cater for this unless an interest floor is explicitly included in the contract.
“Derivatives play a crucial role in financing by allowing borrowers and lenders to hedge risk, for instance related to interest rates. The problem is that derivatives may not be set up to deal properly with negative rates,” said Adam Dann, partner at Berwin Leighton Paisner, a law firm.
Rules set down by the International Swaps and Derivatives Association (ISDA), which is responsible for standardised derivatives agreements, govern how swaps are structured. A “plain vanilla” interest rate swap would not (and should not) include an interest rate floor, but the position is different when a swap is used to hedge interest rate risk in a loan that does include such a floor. See the example in note 1 below for an illustration of the problem that can arise.
“A mismatch occurs when borrowers wish to hedge the loan with an embedded floor using a conventional interest rate swap,” said Nadim Mezher, a director in global banking and markets at HSBC.
“This is because the floating leg of an interest rate swap does not include a zero percent LIBOR floor, thus exposing the borrower to an increase in the combined financing cost should LIBOR turn negative, in the absence of a zero percent floor in the hedge,” he added.
While including an interest rate floor in an interest rate swap is straightforward, pricing it can be challenging. Mark Battistoni, managing director at Chatham Financial, the world’s largest independent interest rate and foreign exchange risk management advisor, believes parts of the derivatives markets have had a very hard time adapting to negative rates.
“Models need to be revised or scrapped in favour of new ones – in particular for interest rate options such as caps and floors,” he said. “The pace of change varies by banks, so even now, the product capabilities and price differential between mainstream banks for some hedging products is shockingly wide.”
The problem for loan agreements
In the lending context, the problem posed by negative rates is clear: if the reference rate in a floating rate loan falls below zero, the lender won’t receive the full margin for which it bargained. And if the reference rate moves far enough into negative territory, the lender could, in theory, end up having to pay the borrower interest.
The obvious solution is for the loan agreement to include a zero floor for the interest rate payable, so that the lender never has to pay interest to the borrower. The Loan Markets Association (LMA), which maintains standard form documentation for the loan syndication market, is understood to have recommended the inclusion of such a provision. But not all transactions are documented using LMA documentation, and older deals may not include a zero floor.
"In some sectors - like the leveraged corporate space which is dominated by institutional debt providers - LIBOR floors have been prevalent at levels above zero for a number of years,” said HSBC’s Nadim Mezher.
“Now that negative interest rates have become a reality in some currencies and a possibility in others, many lenders are requiring zero percent LIBOR floors on loans. This is required to protect lenders' loan margins as some central banks have begun charging banks for excess reserves in markets where policy rates are negative, while banks in general have yet to pass on this cost to their retail and corporate clients," added Mezher.
Peter Cosmetatos, chief executive of CREFC Europe, said: “There are numerous unintended consequences arising from negative rates. One issue, historically as well as for new deals, is ensuring that both loan agreements and related hedging arrangements all work and fit together as they should. Addressing risks in that area is likely to carry a cost.
“More broadly, our sense is that, while most lenders remain disciplined and responsible, the monetary policy environment is creating perverse drivers and unintended risks in cyclical real estate markets. Crucially, real estate investment has a key role to play in economic recovery across the world. And while only five central banks currently have negative rates, their jurisdictions account for almost a quarter of global GDP, and the international nature of real estate capital flows means that knock-on effects will impact in many markets.”
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